TheMarketForIdeas

Motto:

“While ever human history its age-old course will ply,

As on time’s heavy anvil blind hammers heedless fate.”

Emperor and proletarian, by Mihai Eminescu

(transl. Corneliu M. Popescu) 

Over the past two years approximately, inflation has resurfaced in Romania. Initially, price increases appeared to be temporary and due to purely external causes: international commodity market tensions and supply difficulties in a context of strong recovery of the global economy after the end of the pandemic restrictions.[1] Thereafter, inflation was found to be persistent and fueled by domestic factors, both on the supply and demand side.[2] In the short term, the most recent and possibly the most important cause of inflation has been the increase in energy prices exacerbated by the war in Ukraine. In the medium to long term, inflationary pressures are likely to increase as a result of structural factors such as imbalances in the Romanian economy, stagnating investment, demographic decline, a shift to (more expensive) green energy etc. The way these factors act and combine is specific to the Romanian economy, and, as a result, a monetary policy adapted to indigenous realities is necessary. The monetary policy decisions taken by the Fed, the ECB and the other central banks in the region that are not part of the euro area will also be of particular importance. These external decisions are important in view of the evolution of the interest rate differential and the orientation of international capital flows into which the Romanian economy is inserted.

The main challenges currently faced by the National Bank of Romania (NBR) are: preventing excessive deviation of the inflation rate from the target (2.5 % ± 1pp); not surrendering to requests for interest rate cuts in order to stimulate economic growth in the short term; withstanding pressures for indirect financing of the budget deficit.

Currently, the NBR is relatively well positioned to face all these challenges, in particular the economic and political pressures that typically arise from the tightening of monetary policy. Its strong points are the provisions of the law on its organization and functioning, which prohibits it from granting loans to the State (Articles 6.1 and 7.1 of Law No 312/2004), the external support which it enjoys as a member of the European System of Central Banks (ESCB) and the institutional expertise acquired during the post-communist period.[3] This expertise covers three important areas: management of supply-side shocks; budgetary sustainability; balance between established practices and new ideas and information. 

Management of supply-side shocks 

Supply-side shocks are not generally the result of monetary policy but have their roots in the real economy. This type of shock strongly manifested itself in the first two decades after the fall of communism, due to the disruption of the production apparatus of the planned economy and the hesitation of the authorities ‘emanating’ from the revolution to carry out the necessary reforms to establish the market economy.[4] From 1992 to 2009, the author was a member of the Board of Directors of the NBR and sought to contribute, as per his prerogatives, to assessing the impact of supply-side shocks, to understanding the mechanisms by which their temporary as well as lasting effects are being passed on to the economy and to designing ways of managing demand. Many colleagues in the management of the NBR and its staff did the same.[5]

Part of the problem is that, faced with high inflation, economic operators have been inclined to index their prices and salaries.

During the communist era, inflation was hidden – as prices were fixed by the State, independently of supply and demand and kept unchanged for a long period. The imbalance between (higher) demand and (lower) supply was made apparent in the disappearance of goods in shops, queues, rationing cards, etc. rather than through price increases. After the fall of communism, the imbalance between supply and demand increased, but prices were liberalized and consequently increased very rapidly. As a result, inflation became a prominent topic, yet those discussing it were not necessarily doing so from an expert position but rather from a position reminiscent of communist propaganda.

Independently of this, society’s awareness of inflation means that, if the central bank fails to act in time, price and wage pressures increase, inflation expectations quickly outweigh monetary policy and temporary situations end up with lasting effects.

According to the textbooks, the optimal response to supply-side shocks is the absence of any reaction, as in a market economy these shocks will dissipate themselves. However, Romanian society, traumatized by penuries of all kinds during the communist rule and by the reversal of social positions during the transition period, has little tolerance for the loss of purchasing power and calls for close indexation of wages and other nominal income. The consequence is that, once inflation emerges, it becomes what is known as ‘inertial inflation’. Monetary policy measures are therefore often needed to deal with supply-side shocks, although the quantity of goods and services available for consumption depends, in the long term, on real inputs (capital, labor, technical and organizational knowledge, etc.) rather than on money.

The NBR’s solution to curbing inflation expectations was the adoption of the monetary policy strategy called ‘direct targeting of inflation’. The need for such an approach was driven by the high inflation rate in the previous period, which led economic operators to expect that prices would continue to increase rather than remain stable. The size of inflation has thus become an important factor in decisions taken by both people and businesses, and this had to be taken into account in the design and implementation of monetary policy. As with other emerging market economy countries, this strategy worked relatively well and gave flexibility to monetary policy. 

Fiscal sustainability 

The second area of expertise falls within the remit of the NBR’s mission, which is to ensure and maintain price stability. It is to be noted that monetary policy and fiscal policy pursued by the Romanian authorities are often divergent and reveal what is called “budgetary dominance”. This is illustrated by purchases of government securities on the secondary market by the central bank, which, while constituting an established monetary policy instrument (open market operations), are economically equivalent to indirect monetary financing of the State. In fact, even when government bonds are not definitively purchased by the central bank on the secondary market, loans granted by commercial banks to the State fuel a process of credit and money multiplication within the commercial banking sector without the participation of the central bank. This multiplication process leads to monetary growth faster than the quantity of goods and services available for exchange and thus to higher prices. It is therefore essential for NBR’s mission not to be burdened by budgetary domination, either directly or indirectly.

In order to be economically efficient, a country needs an overall strategy with several categories of positive effects, including fiscal sustainability. Without such a comprehensive strategy, the central bank alone cannot ensure price stability.

Romania is a good example of this. Between 2014 and 2016, the NBR was able to reduce inflation without harming economic growth and without the economy entering into deflation, while the budget deficit and public debt were low. The main elements of this remarkable performance were: managed floating exchange rate, which has spared the country from costly and probably unsuccessful foreign exchange interventions by the central bank; the targeting of inflation, which has led to low interest rates and stable prices; finally, and in particular, budgetary austerity.

These factors helped Romania overcome the difficulties of the transition but imposed financial discipline and caution. As a result, monetary policy was not highly appreciated; on the contrary, it attracted numerous criticisms of the NBR.[6] This atmosphere has undoubtedly contributed to the populist orientation of fiscal policy in the coming periods, when the volume of public expenditure increased and its quality was almost completely overlooked. The NBR maintained its anti-inflationary stance of monetary policy, but this factor turned out to be insufficient as macroeconomic imbalances widened and economic growth slowed down. 

Road to equilibrium 

The third area of expertise of the NBR is the design and implementation of monetary policy in such a way as to strike a balance between, on the one hand, standard instruments (open market operations; standing facilities granted to credit institutions; minimum reserves) and, on the other, openness to new ideas, information and practices.

In advanced economies, especially in recent years, unique thinking has undoubtedly been a major problem for monetary policy. This concerns in particular quantitative easing, which was adopted by the main central banks to stimulate economic recovery and is now seen as an important cause of inflation in those economies. The NBR does not publish the results of the voting by its board of directors, but it is to be assumed that, if the issue on the agenda is the tightening of monetary policy, unanimity cases are rare, especially as regards the percentage of interest increases taken as such. After all, the members of the board are appointed by the parliamentary parties and it is to be expected that, beyond their professional knowledge, they are inspired by different ideologies. In any event, my experience is that it is not the diversity of opinions that is lacking in the collective management body of the NBR.

In our view, what Romanian economic policy makers need now is consensus on the overall strategy and a plurality of views on tactical issues.

The NBR’s mission is to protect the value of the currency with a view to balanced and sustainable economic growth. While open discussions on various aspects of central bank action are welcome, it not useful to call into question and continuously criticize this fundamental role of the NBR. The diversity of opinions is normal, yet questioning everything is not desirable.

At a time when Romania is experiencing higher inflation than other countries, the elements on which consensus is necessary and which should to be discussed need to be defined. Monetary policy makers take difficult and challenging decisions on the basis of insufficient information and under conditions of uncertainty. Critics often ignore this complexity and simply state that the central bank incapable of grasping reality. Therefore, the NBR must always repeat its strategic objective with patience, clarity and in appropriate forms. Whatever consensus is reached, it must be reinforced by convincing arguments, not weakened by the insinuation that it is the result of unique thinking. On the other hand, it is desirable to open up and exchange views on tactics.

As I have shown above, fiscal policy can shift monetary policy away from the objective of price stability. In Romania, this phenomenon should come to an end, especially since the recovery in question is an important condition for the country to benefit from the significant amount of EU funds made available to it. Unfortunately, according to the latest assessments of the NBR, macroeconomic tensions in the context of twin deficits continue to pose a major systemic risk.[7] Therefore, sustained efforts are needed to effectively implement the reforms and investments set out in the “National Recovery and Resilience Plan” (NRRP), which addresses the main macroeconomic challenges facing Romania today, including the sustainability of public finances.

Given the economic downturn and the acute need for financial resources, inflation is likely to remain high for the foreseeable future. However, better coordination of fiscal and monetary policy creates synergies that can mitigate the consequences of supply and demand shocks and keep the costs of financing economic activity and the state at a bearable level. This way, people and businesses would cease to fear rising prices. 

Photo source: PxHere. 

Notes:

[1] S. Cerna, S-a întors inflația: ce e de făcut? https://www.contributors.ro/s-a-intors-inflatia-ce-e-de-facut/#_ftn.

[2] Idem.

[3] S. Cerna, Banca Națională și schimbarea la față a României, https://www.zf.ro/banci-si-asigurari/silviu-cerna-membru-consiliul-administratie-bnr-timp-17-ani-19981179, http://www.oranoua.ro/silviu-cerna-membru-in-consiliul-de-administratie-al-bnr-timp-de-17-ani-povesteste-cum-au-fost-inceputurile-banca-nationale-cand-nu-avea-resursele-umane-pentru-a-realiza-tranzitia-si-cum-independen/.

[4] S. Cerna, Tranziția și grupurile de interese, Œconomica, 2, 2011, p. 15-27, https://www.researchgate.net/publication/236904958_tranzitia_si_grupurile_de_interese.

[5] S. Cerna, Banca Națională și schimbarea la față a României, ed. cit.

[6] S. Cerna, Banca Națională pe banca acuzațiilor, Piața Financiară, Nr. 12-01 (265-266)/2017-2018, p. 22-24;

https://www.researchgate.net/publication/323143522_banca_nationala_pe_banca_acuzatilor.

[7] F. Georgescu, Discurs în cadrul Conferinței anuale BNR-ASE – Navigând printre crize suprapuse, https://www.bnr.ro/Discurs-in-cadrul-Conferin%c8%9bei-anuale-BNR-ASE---Navigand-printre-crize-suprapuse-26012.aspx.