Inflation dynamics and monetary policy

Achieving and maintaining a low level for inflation rate is a key objective of macroeconomic policies given the negative consequences of a high inflation rate (arbitrary redistribution of wealth, distortions in market mechanisms and relative prices). In this context, central banks are formally charged to ensure price stability, which means to limit the increase in consumer prices at around 2% per year.


Achieving price stability - a difficult task
Ensuring and maintaining price stability is also the main objective of the National Bank of Romania (NBR). However, the inflation target fixed by the NBR is a bit higher (2.5% with a fluctuation band of +/-1%) compared with ones set by central banks in well developed economies and this in order to take into account the expected convergence in Romanian prices (lower) towards the  levels in the Euro Area (higher).
Given the subdued economic growth, central banks' concerns on inflation were low over the last few years. Major central banks in developed economies put in place non-standard quantitative easing policies, while many central banks in developing economies had also room to ease the monetary policy stance. Dynamics of inflation is another area were Romania remarks on the negative side (high inflation rates). In spite of a prolong recession during the past four years, Romania recorded the highest inflation rate among the EU member countries.  Implied average annual inflation rate between end-2008 and end-2012 amounted to 5.1%. Advance in prices was fuelled in some extent by hike in VAT from 19% to 24% (in July 2010) and by increase in excises (hike in their level and leu depreciation). When adjusting for taxes contribution, resulting inflation rate amounted to 3.2% per year between end-2008 and end-2012. This is still the highest level among the EU member countries and above the central bank's inflation target assumed for the next years.
Strong impact from supply side shocks
Changes in food prices and administered prices have a strong impact on inflation dynamics in Romania. Foods and non-alcoholic   beverages account for 32% of the HICP basket, which is the highest level among the EU member countries. Food prices, especially the ones for fruits and vegetables, depend in a large extent on weather conditions: a good agricultural year cause downward pressures in volatile food prices, while a bad agricultural year generate important upward pressures on volatile food prices. Over the last years, weather conditions were very volatile and this resulted in large swings in volatile food prices and in overall inflation rate. Administered prices have also a large share in consumption basket. Not only they increased much faster than most other prices in the past, but also their dynamics was also volatile at some times. While the impact of supply side shocks on short-term inflation dynamics is evident, they might have also impact on inflation dynamics in medium and long-term by limiting the speed of the disinflation process. Inflationary expectations might inflate each time the inflation rate climbs at a high level even though this is only a transitory development (i.e prices for fruits and vegetables increase in case of a bad agricultural year, but decrease subsequently). So, the failure to anchor public inflationary expectations to the central bank's inflation target or to the medium term trend in inflation rate might be a reason for the high persistence in inflation rate.
Adverse  weather conditions last year had a strong negative impact on agricultural output  and on volatile food prices (fruits, vegetables) which increased by 19.1% yoy as of end-February 2013 and had a contributions of 1.3 percentage points to inflation rate (5.7% yoy). When adjusting for their contribution, the remaining prices advanced by 4.7%. This is much closer to our estimates for medium-term trend in inflation rate (close to 4%). in fact, the annual inflation rate should decelerate towards 4% yoy by end-of the year when the adverse statistical base effect (stemming from increases in volatile food prices in H2 2012) will disappear.

Implications for monetary policy
Given that inflation dynamics is very sensitive to factors outside the control of the central bank (supply side shocks), the Romanian central bank has a lower control over it compared with other European central banks. Weather conditions can have a strong impact on inflation dynamics in the short-run (two to four quarters) due to their impact on agricultural output and volatile food prices which have a large share in consumption basket. Resulting high volatility in inflation rate might limit the speed of disinflation process in the medium and long term. There are also other factors which fuel the inflation rate in the long-term and which are outside the control of monetary policy. As in the past, inefficiencies of state-owned companies might result in higher prices to be paid by final consumers. Due to a low economic development, general level of consumer prices in Romania is lower compared with the other European developed economies. As real converge process is going forward, prices in Romania should grow at a faster pace compared with the other EU countries. So, inflation rate in Romania might be higher compared with inflation rates in the other developed EU member countries. The liberalization oflocal energy market is expected to result in upside inflationary pressures (i.e. prices for electricity and natural gas are planned to increase consistently above the central bank's inflation target in the following years). The failure of central bank to meet its inflation targets in the past might weigh on its ability to anchor inflationary expectations in the future as well.
As in the past years, we believe the central bank would continue to face important challenges in meeting its inflation targets and achieving the key objective of price stability. The pace of disinflation process is likely to remain slow in the following years.  
Faced with important constraints in attaining the price stability objective, the National Bank of Romania focuses also in a large extent on the objective of maintaining financial stability. In fact, this objective has received an increasing importance by the NBR as well by the other central banks due to negative implication of recent economic and financial crisis. Due to high share of foreign currency denominated loans in total loans (62%), the NBR has important concerns about large depreciation of the leu which has a negative impact on financial position of households and companies. So, the NBR is using a managed floating exchange rate regime and it often steps in the FX market to smooth leu exchange rate fluctuations.

The monetary policy transmission mechanism and the monetary policy instruments used by the NBR to control inflation dynamics have some peculiarities. In order to achieve its objectives (price stability and financial stability) the central bank is using several instruments: monetary policy rate, management of liquidity in the banking system, FX interventions and moral suasion. 
Experience since the introduction of inflation targeting in Romania (August 2005) shows the central bank wants to avoid inducing too much volatility in the monetary policy rate. Not all increases and decreases in the headline inflation rate are accompanied by a change in the monetary policy rate. With a very volatile headline inflation rate, the key focus of central bank is on core inflation and inflationary expectations. The central bank starts to increase the monetary policy rate when it is confident enough that core inflation and inflationary expectations will deteriorate in medium term. Similarly, the central bank starts to decrease the monetary policy rate when it is confident enough that core inflation will decrease and inflationary expectations will improve. So, a change in the monetary policy rate could be seen as a good signal about a deterioration or improvement in inflation in medium term (6 months - 1 year). 
The management of liquidity in the money market is a very important instrument for the Romanian central bank. This allows it to control not only the dynamics of the interbank interest rates and yields for government bonds, but also the dynamics of the exchange rate. Starting with 2008, the central bank has become a net creditor of the banking system in money market operations. This has substantially increased its ability to manage the dynamics of interbank interest rates and exchange rate by controlling the liquidity conditions in the money market. The central bank tightens the control over the liquidity in the money market (reducing or eliminating the liquidity surplus, or allowing for a liquidity deficit) when upside inflationary risks increase and/or when depreciation pressures emerge for the leu. The NBR is allowing for more liquidity in the money market when downside inflationary risks prevail and/or sentiment in the market is positive for the leu. Flows between companies and the Finance Ministry (payment of taxes, money received for goods and services provided to public authorities) have a strong impact over liquidity conditions in the market due to their large size and pattern (monthly and quarterly seasonality). The central bank does not always smooth the impact of these flows, allowing them to induce a surplus or a deficit of liquidity in the market. So, while central bank does keep unchanged the monetary policy rate, in short-term (even several months in a row) it can induce a move in the interbank interest rates and bond yields by tightening or loosening the liquidity conditions in the market. This makes interbank interest rates and yields to have different dynamics than monetary policy rate and to be much more volatile. 
Ultimately, high volatility in inflation rate and in interbank interest rates and slow disinflation results in high persistence in RON lending interest rates charged by banks to population and companies. Similar to inflation rate, they declined only gradually in the past years.

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