The labor market is overheating, the wider economy not yet
The economy continued to boom in Q1 2018. Real GDP grew by +4.4% y/y, the same pace as in the previous quarter and stronger than in 2017 as a whole (+4%). Growth in Q1 was driven by domestic demand, notably fixed investment which surged by +17.1% y/y, fueled by a strong absorption of EU investment funds, which we expect to continue in the coming quarters. Consumer and public spending also rose rapidly by +5.1% and +4.6% y/y, respectively. In contrast, external trade activity weakened markedly on softening demand from the Eurozone. Exports expanded by just +3.5% y/y and imports by +3.8% in Q1, less than half the paces reached in 2017. Advanced indicators suggest that the momentum has eased slightly but remained overall robust in Q2. In April-May, industrial production growth slowed to +3.3% y/y, reflecting the cooling external demand, while retail sales growth (+6.8%) remained buoyant, indicating continued sound consumer spending. Overall, we forecast +3.8% GDP growth in 2018 as a whole.
Chart 1 Currencies – changes versus the EUR
...but weakening currency
Despite the strong economic activity, the Hungarian forint (HUF) has weakened markedly in the first half of 2018. The HUF reached an all-time low of 330 per EUR at the end of June, having lost -5.9% in value in H1, most of that in May-June (-4.9%). This made it the second-worst performing currency in the Emerging Europe region – only the Turkish lira lost more in value (see Chart 1). In 2017 as a whole, the HUF had still slightly appreciated by +0.7% against the EUR. How is the recent weakening to be explained?
Fiscal stimulus should be offset by monetary tightening
The strong economic impetus since mid-2017 in particular has been fueled in part by pro-cyclical fiscal stimulus. VAT rates on various products were lowered while public sector wages were raised. The latter combined with a tightening labor market (unemployment fell to 3.9% in Q1) has pushed up overall wage growth (+12.4% y/y in Q1) and accelerated consumer spending. Corporate taxes were also cut which has mitigated the impact of wage growth on corporates as well as inflationary pressures until early 2018. However, the recently proposed 2019 budget proposes cuts in social contributions as well as more hikes in public sector wages. This has raised concerns about a further overheating of the labor market and adverse effects for the wider economy, explaining the loss of confidence in the HUF. Moreover, monetary policy has remained very loose for now. The key policy interest rate was again kept at 0.9% in June, even though CPI inflation rose to 2.8% y/y in May and 3.1% in June (up from 1.9% in February).
That said, other macroeconomic fundamentals have remained in check so far. Private sector credit growth has remained modest at +3.3% y/y in April. The current account balance posted a solid surplus of +EUR1.4bn in the first four months of 2018. The fiscal deficit is expected to widen as a result of the fiscal stimulus measures but should remain well below -3% of GDP in 2018.
Summarizing, the overheating labor market and the depreciating HUF need close monitoring. However, the Central Bank has the tools to rein in the risk of a full-blown overheating and recent comments suggest that it is ready to tighten policy if needed. We expect the first interest rate hike to come in early 2019, at the latest.