– SUMMARY –
Inflation rate evolution and its causes
In September 2008, the 12-month inflation rate stood at 7.30 percent, down by 1.31 percentage points against June, when the reading was 8.61 percent. This development confirms the previous projections of the National Bank of Romania (NBR) according to which disinflation would resume starting 2008 Q3.
Among supply-side factors, the rebound in agricultural output – in the wake of the adverse shock during 2007 – acted as the major determinant of the slowdown in inflation. This performance impacted in particular the volatile prices of some food items, with cheaper fruit and vegetables offsetting the opposite effects on inflation dynamics exerted by developments in administered prices and fuel prices.
The mismatch between payroll increases and productivity gains during June – August 2008 as compared to the first five months of 2008 led to further increases in unit labour cost, generating inflationary effects through both the pressure of higher wages on excess demand and cost-push pressures on producer prices.
The uptrend in annual CORE2 inflation, which had been manifest since August 2007, came to a halt in 2008 Q3. The effects of higher aggregate demand pressure on core inflation were countered by the significant slowdown in the growth rate of prices for processed foodstuffs included in the CORE2 basket, the favourable influence of a stronger domestic currency versus the euro on import prices and relatively lower inflation expectations. Against this background, CORE2 inflation dynamics in the third quarter of
2008 was slower than that of the overall CPI inflation, thus contributing to the latter’s deceleration.
In 2008 Q2, ongoing acceleration of economic growth (to 9.3 percent) fuelled inflationary pressures triggered by excess demand. Behind the GDP growth stood the surge, albeit slightly decelerating, in both investment and household consumption, underpinned by sizeable increases in the incomes of companies and loans to the private sector, as well as by the advance in public expenditures.
The slowdown in domestic demand dynamics was more than offset by the marked decrease in the negative contribution of net external demand to GDP growth. The gradual and significant narrowing of the trade deficit started in the final months of 2007. The consolidation of this trend led to exports growth outpacing imports in 2008 Q2 and Q3 (until August) for the first time since 2002 Q4.
Monetary policy since the release of the previous Inflation Report
On 31 July 2008, the National Bank of Romania Board decided to raise the monetary policy rate to 10.25 percent per annum. Subsequently, global and domestic macroeconomic developments sent diverging signals regarding the medium-term inflation outlook. As a confirmation of NBR projections, the annual inflation rate re-embarked on a downward trend after reaching a peak in July. The growth of credit to the private sector began slowing gradually, whereas the exchange rate of the domestic currency posted greater volatility and a trend reversal, from appreciation to depreciation, towards the end of 2008 Q3. Inflationary pressures exerted by aggregate demand increased due to the faster second-quarter economic growth while real wages continued to overtake productivity gains. In addition, while coming closer to the country’s general election date (Nov 30), the risk of looser fiscal and income policies became more relevant.
The deepening of the global financial crisis (especially starting September) led to a sizeable increase in uncertainties surrounding the world economic outlook, as well as concerning their implications on the Romanian economy. The broad-based global financial deleveraging process, resulting in increased risk aversion and a subsequent flight to quality of non-resident investors’ capital began to gradually, but ever more strongly affect emerging economies, entailing substantial volatility of local currencies.
To date, emerging market currencies have been mostly subject to downward pressure.
In this global context, the probability of a significant direct impact of financial deleveraging on the
Romanian economy appears to be remote, given the information available thus far. A contributor to this state of affairs is the still low financial intermediation in Romania* and the lack of significant exposure of the financial and banking system to the financial instruments lying at the root of the crisis (subprime mortgage-backed securities)**. Under such circumstances, the deepening of the international financial crisis is expected to affect domestic economic activity mostly indirectly, via the impact of the envisaged flagging aggregate demand in the euro area on Romania’s exports dynamics. This indirect influence is enhanced by the tightening of domestic lending conditions along with the rises in external financing costs and debt service of economic agents, especially those exposed to foreign currencydenominated debt. Amid growing uncertainties, both the magnitude and duration of these processes are difficult to assess.
In response to the domestic macroeconomic developments and the global environment affected by heightened uncertainty, the NBR Board decided to keep the monetary policy rate at 10.25 percent per annum in its meeting of 25 September. The decision was meant to strike a balance between the gradual tightening of real monetary conditions once inflation has resumed its forecasted downward trend, with the aim of fulfilling the medium-term disinflation objectives, and ensuring an adequately prudent policy stance is maintained when faced with the emergence of new risk sources at macroeconomic level.
Inflation outlook
The recent deepening of the global financial turmoil caused a marked rise in volatility on world markets, posing major difficulties to forecasting the nature, magnitude and duration of the effects of the crisis on the domestic economy. Therefore, the quantitative assessments in the baseline scenario of the current projection are afflicted by a higher than usual degree of uncertainty. Against this background, the baseline scenario describes, to a far greater extent than in the previous exercises, a possible trajectory of inflation strictly conditional upon the adopted assumptions and the information available upon preparing the forecast. Consequently, deviations from the projected inflation path are more likely to occur in both directions in the current forecasting round, the identified risks being more balanced as concerns their upside versus downside impact on inflation than in the previous rounds.
The baseline scenario of the current projection places the 12-month inflation rate at 6.7 percent for end-
2008, 0.1 percentage points above the figure published in the August 2008 Inflation Report. For end-2009, inflation is forecasted to stand 0.3 percentage points above the previously projected level (4.5 percent versus 4.2 percent), which places it at the upper bound of the variation band around the end-year target.
The new projection puts the inflation rate trajectory above that presented in the August 2008 Inflation Report until end-2009. Compared to the previous projection, the factors boosting forecasted inflation include: more pronounced pressures from CORE2 inflation, which could be associated with higher pressures exerted by aggregate demand, as reflected by faster GDP growth in Q2 and expectations of robust GDP increase in Q3; looser fiscal and income policies expected during the projection horizon; a less favourable evolution of import prices as well as the assumption of a somewhat slower decrease in inflation expectations in the first part of the forecast horizon; and the assumed more rapid increase in administered prices. Such unfavourable influences are mitigated throughout the forecast horizon by the more favourable scenario regarding fuel price inflation. Adding to these influences is the difficultto-precisely-assess effect of global financial turmoil on euro area economic activity, which may spill over quickly into the deceleration of domestic economic activity.
In light of the currently available data and taking into account the unusually high uncertainties, the baseline scenario of the projection assumes a noticeable slowdown in the growth rate of aggregate demand over 2009, given the combined pressures of successive monetary policy rate increases, the recent prudential measures taken by the NBR in order to curb lending growth, the temporary rise in the costs of both foreign borrowing and debt service of economic agents exposed to foreign-exchange denominated debt, as well as of the constraints on credit dynamics owing to the global financial turmoil. The envisaged deceleration in the pace of increase of euro area external demand for Romanian exports is seen as restricting the pace of domestic economic activity and, in turn, excess demand. Moreover, a slowdown in the dynamics of domestic absorption components, particularly private consumption, is projected, translating into a deceleration of import expansion. This development will pave the way for the controlled reduction of excess demand, with the projection foreseeing a temporary elimination of excess demand in 2009 Q2 and Q3, thus favouring disinflation.
Subsequently, the pace of economic growth is seen returning to somewhat higher levels, insofar as the constraints triggered by the global financial crisis diminish gradually.
The NBR will further channel its efforts to driving the inflation rate towards the established targets while striving to ensure the adequate functioning and stability of the financial system amid the adverse effects of the global financial crisis. To this end, the firm monetary policy stance will be retained throughout the projection horizon. This will help bring inflation back within the variation band around the central target in the latter part of the forecast horizon, conditional upon adequate support from the other macroeconomic policies and the absence of any significant slippages from the coordinates of the baseline scenario.
The major uncertainties surrounding the effects of the global financial turmoil on the world economy and on the national economy have serious consequences both on the layout of the baseline scenario of the current projection and on identifying and quantifying the effects of risk factors most likely to become manifest during the current forecasting round. Compared to the previous rounds, risk factors associated with global market developments become increasingly relevant for the current projection due to the recent surge in the global financial crisis and the expectation of its more persistent effects on domestic economic developments in the medium term. The current projection round is characterised by relatively balanced upside versus downside inflation risks, whereas the specific macroeconomic environment in the previous rounds had tilted the balance of risks mainly towards scenarios indicating upside risks were prevalent.
Thus, the risks accompanying the movements in oil and other commodity prices, administered prices and volatile food prices, as well as the risks associated with exchange rate dynamics are relatively symmetrically distributed against the projected trajectories. Special importance is also attached to asymmetric risks: on one hand, the risks of higher inflation due to real wage growth overtaking productivity gains and a more expansionary fiscal policy; on the other hand, the threat of lower inflation, which is likely to occur following a faster slowdown in economic growth than in the baseline scenario, under the impact of the global financial crisis.
Monetary policy in sight
Considering the new coordinates of the medium-term inflation forecast as well as the complexity associated with the numerous uncertainties, the NBR Board has decided in its meeting of 30 October 2008 to keep the monetary policy rate unchanged at 10.25 percent per annum. At the same time, the NBR Board has decided to lower the minimum reserve requirement ratio on RON-denominated liabilities of credit institutions to 18 percent, from 20 percent previously, starting with the 24 November – 23 December 2008 maintenance period. This decision is aimed at improving liquidity management given that the trend of gradual reduction in excess liquidity in the banking system and, implicitly, in the central bank’s net debtor position in its relation with credit institutions – as signaled by the NBR starting April 2008 – has become more pronounced of late. Moreover, the current 40 percent minimum reserve requirement ratio on foreign currency-denominated liabilities of credit institutions was left unchanged. By taking these measures, the central bank is acting in a proactive manner towards consolidating the traditional monetary policy transmission channels with a view to ensure sustainable financing of the economy amid the anticipated slower dynamics of foreignexchange loans as the effects of the global financial crisis continue to spread.
The NBR seeks to fulfil its medium-term objectives by pursuing sustainable disinflation which can only be achieved by avoiding the aggravation of macroeconomic disequilibria and by maintaining financial stability.
Against this background, the NBR Board has restated the need for the steady and sustained monetary policy efforts aimed at countering demand-pull inflationary pressures and anchoring inflation expectations to be supported by strengthening the other components of the macroeconomic policy mix and speeding up structural reforms.
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Notes:
*) The annual weight of non-government credit in GDP amounted to 38.9 percent in 2008 Q2, compared to an average of 48 percent in Poland, Hungary and the Czech Republic.
**) A limited direct impact of the financial crisis is also due to the measures taken over time by the National Bank of Romania to improve prudential supervision, increase policy efficacy and enhance financial stability. Special mention deserve the relatively high level of reserve requirements associated with foreign currency-denominated liabilities of credit institutions and also the recent prudential measures aimed at dampening credit expansion.
Source: National Bank of Romania (Nov 3, 2008)
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