BNR’s Inflation Bias
The National Bank of Romania’s (BNR) recent decision to leave its interest rate unchanged, despite inflation surpassing the 4% threshold, has been justified as a prudent decision in the face of international uncertainties with adverse effect on growth and “preemptive” rate cuts in several advanced and emergent economies, but it is also a testimony to the Bank’s inflationary bias and even of its shaky real policy independence.
To begin with, among European central banks, BNR has one of the highest and most flexible inflation targets, 2.5% annually with a +/-1% variation band, that is more than 0.5%/1.5% higher than the ECB’s inflation target of under 2% price growth, which it wants to join one day. Nevertheless, BNR has so far proven incapable of hitting this flexible inflation number since its establishment in 2013 and has only achieved an inflation target whatsoever only twice since this framework became official policy almost a decade and a half ago (in 2012 and in 2007 when the target was 3% and 4% respectively, always with a -/+1% variation band). Worse still, BNR now seems to apply a different standard than just a few years ago in assessing its inflation performance for no apparent reason than a change in the ideology of the party in power.
During the disinflation that followed the 2008 crisis, BNR came under heavy criticism from the center-left for keeping monetary policy too tight and inflation too low. Indeed, after reaching 3.3% in 2012, the best fit so far inside its target upper-bound interval, and 4% in 2013, the inflation rate slipped to 1.1% in 2014, - 0.6 in 2015, -1.5 in 2016, and only recovered to an acceptable rate of 1.3%, close to its target’s lower bound interval, in 2017. In answering its critics who suggested more aggressive interest rate cuts, even zero rates, BNR emphasized the stability of the core CPI number and the core CPI forecast as well as the transitory downside effects of the government’s VAT tax cuts on the headline inflation rate – which was a reasonable and acceptable argument to make at the time – in favor of keeping the interest rate at 2%, despite 7% headline unemployment. Now, however, with inflation reaching 4.6% last year and unemployment falling to a little under 4%, since the end of last year, the data situation has reversed. As the latest monetary policy minutes (dated August 5th) emphasize, the core CPI is on the rise and the government’s deficit spending is clearly putting upside pressure on the headline inflation rate, which will remain at 4% according to forecast, but BNR chooses not to act, leaving its policy interest rate unchanged at 2.5%, only 0.75% above its post-recession low.
The most positively inclined reading of BNR’s apparent dual standard in setting monetary policy over the past half a decade is that the Bank is actually engaging in a form of covert price level targeting over the medium term. The fact that it now tolerates an inflation rate that is almost double its flexible target is, in this reading, not evidence of inflation bias – and neither was the negative inflation rate during 2015-2016 evidence of some sort of rare deflationary bias – but a deliberate strategy to make up for the fall in the price level over the period. Annual inflation rate numbers do not matter much in this case, despite the Bank’s official inflation targeting policy, only the CPI level over the medium term. But if such a covert BNR price level targeting strategy were to continue for so long since Romania got out of deflationary rates, it does not explain the three consecutive monetary policy decisions to raise the interest rate by 0.25% in the beginning of last year.
So what exactly is happening with BNR’s monetary policy? The monetary policy environment that BNR faces starts to resemble the familiar mine-filled monetary policy environment since before the Great Romanian Disinflation. True, the repercussions from an international trade war, especially a US-EU trade war, could be very important for the Romanian economy, whose industry has become entangled in the production of car parts and other inputs for major Western European exporters (which explains why the recent monthly fall in German industry seems to correlate with the monthly fall in Romanian industry), thus giving some support to the idea that BNR’s interest rate passivity is also a form of “preemptive” monetary policy. But with no indication of subdued CPI pressure, the cost-competitiveness boost to industry will be achieved to the detriment of BNR’s price stability mandate.
Things are, however, more complicated than this simple trade-off between lax monetary policy and industry competitiveness, on the one hand, and price stability, on the other hand. What matters most for the cost competitiveness of industry is not so much the interest rate that BNR sets, but the value of the national currency. And, in this regard, BNR’s policy transmission is again broken. As before the Great Recession, high inflation seems once more to cohabitate with an apparently strong RON, due to policy interest rate differentials between Romania and the Eurozone, as well as other monetary jurisdictions such as Sweden and Switzerland, in particular, which generate speculative short term capital inflows into the country. These interest rate differentials currently stand at 2.5%, 2.75% and 3.25% respectively, and they are responsible for the RON’s recent appreciation despite a fall of remittance-income inflow in the current account. This means that BNR risks not only to miss its elusive inflation target, but in the process of trying to fix other things, such as lower competitiveness due to international trade tensions, it will fail at both.
If the past is any guide for the future, BNR’s capacity to hit several targets and achieve several objectives at once in this complicated domestic as well as foreign policy environment, which it can only partly control, is not only bound to fail, but might even enhance rather than diminish the vulnerability of the Romanian economy to a future crisis, as has happened in the period leading up to 2008/2009.
(Illustration by Jan Fyt – A hound with a rabbit and a musket in a landscape)