Analysts and the market in general increasingly expect the National Bank of Hungary (MNB) to take measures to protect the Hungarian forint, which has sunk to an all-time low against the euro. The central bank has to weigh four scenarios, of which only one appears to be ideal.
As for why and how the forint sunk to such a low point, in can be summed up as follows: amidst significantly deteriorating external market sentiment, global monetary conditions have tightened, while the MNB has stuck to its ultra-loose policies of low interest rates and non-conventional measures.
In the future, the forint's exchange rate will be influenced by two external market factors in addition to the MNB's policy: global investor sentiment (e.g. trade wars, growth risks) and the monetary policies of major central banks. Of course, these two are not independent of each other, but their interplay nevertheless yields four possible combinations. (We have assumed unchanged domestic monetary conditions for the following quarters.)
1. Negative sentiment and tightening global monetary policy
The first scenario is that market sentiment remains negative, while developed markets implement tighter monetary policies. This is the least favorable scenario for emerging market currencies, the forint included, and this is what we saw in May and early June. All it takes to realize this scenario is for developed economies (chiefly the U.S. and the euro area) to grow dynamically in the coming period, while investor sentiment remains negative as market players are concerned about a global trade war breaking out, for example.
In this situation, the Fed would have to tighten further, as the economy is strong and tax cuts are driving growth, while full employment could theoretically push inflation upwards. This would lead to capital outflow from emerging markets, especially from countries that do not "follow" the Fed's tighter policy.
The world's leading central banks could eventually find themselves in a difficult situation, as import tariffs could have an overall inflationary effect (if higher prices begin to affect expectations), which would lead to further tightening, while global economic growth would slow, which would justify a loosening of policies.
2. Negative sentiment and looser monetary policy
In this scenario, market sentiment remains negative but the major central banks tighten their policies at a slower rate, for example because they see a risk of slowing economic growth and lower-than-targeted inflation, so they either hold back on raising interest rates (Fed) or delay introducing tighter policies (ECB). In this situation, there would be lower pressure on the MNB to tighten monetary conditions, and the forint would be under lower devaluation pressure. Under unchanged domestic conditions, the forint would still not be able to rebound in this environment, but the pressure to devaluate would be smaller than in the first scenario.
3. Positive sentiment and tighter global monetary policy
A positive market sentiment (the easing of fears concerning trade wars and slower growth) would prop up riskier instruments, so this scenario could theoretically provide the forint with some room to breathe as investors would again turn towards emerging markets in hopes of higher yields. The only problem is, if the central banks of developed countries tighten their policies as expected under this scenario, then Hungarian yields will not be high enough to attract investors. As a result, it is hard to see how the forint would gain given unchanged domestic monetary conditions, as there would be no interest element behind it.
4. Positive sentiment and looser monetary policy
This is the only ideal scenario under which the MNB would not have to tighten its policy. The combination of positive sentiment and looser policies could arise if the risks threatening global growth decrease and inflation remains stuck at low levels (as seen in the year following the crisis), as major central banks would not have to tighten their policies. This outcome is very uncertain as the closing output gap would entail a higher inflation trajectory (even given a flat Phillips curve). Nevertheless, it is these conditions that would offer the best chance for the forint to firm and rebound under unchanged domestic monetary conditions.
It is no coincidence that the MNB is pursuing its current policy, as its proferssional position is tied to the fourth scenario: it believes that in the post-crisis world, inflationary pressure is lower (due to technological, demographical and other reasons). The second and third scenarios would lead to a weaker, or at least sustainedly weak, forint, and investors would find it hard to believe that this would not cause higher inflation.
To sum it up, unless market sentiment improves significantly in the next few weeks and unless investors review their expectations of the future measures of major central banks, the MNB will have to take steps to stop the plummeting forint. Until then, each trading day may bring a new low.
