Monetary policy under import price shocks: the case of Hungary

The general task of inflation targeting for central banks is to find an interest rate path that ensures the achievement of the inflation target by trading off the possible economic sacrifices. Commodities such as oil or food appear directly in the consumer basket, and also serve as input in the production process, especially in the case of oil. Central banks of small, open economies now and again face the problem of dealing with imported price pressures, i.e. terms-of-trade shocks. They often need to judge whether these pressures affect the production side of the economy or inflation expectations, or induce substitution in demand. Imported inflationary pressure can be counterbalanced by nominal exchange rate appreciation; this, however, does not constitute a free lunch, as it can temporarily contract activity in the tradable sector. In this respect, there is a question of whether monetary policies that work under a large terms-of-trade shift would target “domestic” inflation (as in Clarida et al (2001)) sometimes proxied by the “core inflation”, which excludes food and energy prices from the consumer basket, or whether it is optimal to focus on total inflation.