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The pressing matter of inflation is once again on the minds of the citizens and the National Bank of Romania (NBR), whose goal is to preserve and maintain price stability. Over the previous year, inflation has dramatically risen. It continues to include a significant external component, amplified by the economic consequences of the war between Russia and Ukraine, most notably the sharp increases in the price of energy and raw materials. Over the last couple of months, inflation has intensified and spread, leading to it eventually being internalised. As a consequence, the normalisation of monetary policy is necessary.

Inflation soared to 15.1% in June 2022, well above the 2.5%±1pp that the NBR had targeted, ranking amongst the highest increases in Europe. Originally, this growth could be explained by the external shocks manifested on the supply side. After Russia’s invasion in Ukraine, inflation escalated and grew as a result of several internal variables, chief among which was the widening budget deficit.

In this profoundly altered economic environment, the priority of anti-inflationary policies has changed, its focus now settled on supply-side stimulation in order to help boost potential economic growth.^[1] 

1. A high level of internalised and extended inflation 

Starting with mid-2021, the factors underlying the accelerated increase in inflation have converged. A large chunk of Romania's inflation was and still is imported. Imported inflation mainly originates from the tension on the market for raw materials and growing supply issues against the backdrop of a strong global economic recovery after the pandemic. As of early 2022, these difficulties have grown direr as a consequence of the Ukrainian war and the reinforcement of new quarantine measures in some parts of China.

On the other hand, the US’s excessive fiscal stimuli and the population's emergence from isolation, which has increased its consumption of goods rather than services, have both added to the strength of the global demand's rebound.

At present, given the global scope and interconnectedness of the markets for goods, the pressure on the international prices has affected Romania’s economy, even though there has not been an overwhelming demand. Thus, the consumption of goods and services only returned to pre-pandemic levels. However, the economic repercussions of the war in Ukraine were added to these pre-existing tensions, and in March 2022, retail fuel prices increased by 34.2%.

The main cause of inflation is the significant growth of the budget deficit. This dictates the expansion of the “monetary base”^[2] which is the primary driver of currency creation in the banking sector, even when the law forbids the central bank from directly crediting the government. The central bank purchases state bonds (public debt) from commercial banks and exchanges them for “primary” currency (debt monetisation). Additionally, even if the central bank does not purchase government securities on the secondary market (open market operations), the state is still able to expand its credit and currency supply thanks to loans that commercial banks give to the government in exchange for its securities. ^[3]

From an economic perspective, inflation has the same impact as a tax on the income of all citizens: consumers must spend more money to purchase the same amount of commodities. As a result, inflation directly impacts the purchasing power of the population.

When it comes to business owners, they do not automatically include the higher production costs in their prices; rather, their approach takes into consideration the demand for their goods / services and the ability to establish stable prices (monopoly position). Depending on these factors, businesses support a great part or the entirety of the inflationary effect, either by reducing profits or increasing selling prices. 

2. Controlling purchasing power 

The variation in population purchasing power is caused by the comparative dynamics of incomes and prices. According to the most recent data, the inequalities in living standards that separated Romania from the rest of Europe had narrowed at first due to these dynamics, therefore purchasing power increased even throughout the pandemic. At the moment, however, it appears that the purchasing power has started to decline.

The measures taken by the government such as compensations and caps on utility bills for household consumers, providing retirees with pensions bellow 2 000 lei with a one-time support of 700 lei, providing social vouchers worth 250 lei to citizens with low incomes etc., partially mitigated the social and political effects of rising prices. However, the aforementioned actions must remain short-term measures since they widen the budget deficit. Subsidies and price caps, in turn, cause consumption patterns to change in harmful ways and make it impossible to conserve scarce goods or critical resources such as energy.

The minimum wage and the indexation of other social benefits, particularly pensions, were crucial additional steps to sustain the purchasing power of the citizens. Conversely, these measures also further increase the budget deficit and, by extension, inflation. Finally, a significant increase in the minimum wage may set off a price/wage inflationary spiral. In the long run, structural reform is more successful than monetary or fiscal measures in addressing the issue of how inflation affects purchasing power.

Despite the fact that, on average, the population's declining purchasing power was marginal in 2022, Romanian society nonetheless acutely feels the effects of this predicament. A recently released opinion survey found that 44% of the Romanian working population believe that the increases in the prices of utilities, gas, consumer items, apparel, and food has severely impacted their standard of living. ^[4]The macroeconomic metrics (GDP/inhabitant, per capita consumption, average life expectancy, etc.) that show an improvement in the standard of living in Romania during the past few years are far less pessimistic than this perception of the situation. As a result, it is necessary to conduct in-depth research on the phenomenon across two dimensions: the asymmetry of consumer perceptions,^[5] which is naturally more sensitive to price increases than to price decreases or stability, as well as the increase in the prices of frequently purchased goods, such as foodstuffs or fuel.

Pinpointing the motions the Romanian society goes through in order to absorb and spread the costs of the war in Ukraine—which are unquestionably high—is an issue for both authorities and academic economists in general. This cost is less significant for the economy than the impact of the pandemic. Therefore, it does not justify an "at all costs" strategy that would quickly lead to an inability to sustain the public finances, which are already unstable and causing inflation.

As a result, the government must take careful, targeted action to maintain purchasing power. In this context, it cannot replace an effort that is already fairly distributed across the economy i.e. on the part of the businesses, which temporarily cut their profits, and on the part of the general population, which temporarily cuts their consumption; instead, it should instead look out for those who are less fortunate. To overcome the conundrum with viable economic entities in Romania, the distribution of the effort required in the current context is a matter of equality as well as economic effectiveness (for the companies, the population, and public institutions). 

3. Expectations and forecasts regarding inflation 

The trends mentioned previously suggest that we are dealing with a new type of inflation. After the rampant inflation from 1990 to the first half of the 2000s, Romanian consumers, employees and entrepreneurs have not experienced a high inflation rate. This favourable state of affairs has led to a change in the way society and economic decision-makers perceive of inflation, psychologically speaking.

Under these circumstances, the forecasts regarding inflation, strongly linked to the NBR’s target, are an essential factor in maintaining price stability. In order to be able to properly assess and calibrate these predictions, it is necessary to take into account not only the inflation rate, but also its potential evolution. With regards to the monetary policy, medium term expectations (i.e. made on three to five years) are the most important factor to consider, as one-year expectations are strongly influenced by temporary fluctuations in inflation. The problem is that medium and long term anticipations of inflation made by professionals are quite far from the 2%±1pp target set by NBR. These projections are, of course, dependent on the future evolution of energy prices but the concerns associated with Russia-Ukraine war render those forecasts more pessimistic.

The fight against hyperinflation highlights NBR's main responsibility: maintaining price stability. At the Euro-system level, price stability is defined by a medium term inflation rate of 2%. This 2% represents the “thermal equilibrium” of the economy, reflecting the balance between supply and demand. In case of a very low rate of inflation, below 2%, the economy is anaemic due to a decreased demand and risks entering a deflationary spiral. This was the prevailing situation in the US, UK and Eurozone between 2014 and 2021, which justified an accommodative monetary policy achieved through a series of so-called “unconventional measures”. ^[6]

Retrospectively, it can be said that the accommodative monetary policy was a necessity, as it proved quite effective in preventing deflation.^[7] This has been a valid statement until recently, for during that period, inflation was mainly caused by the increase in energy prices along with supply chain disruptions. Currently, however, the situation has changed and it requires the “normalisation”^[8] of the monetary policy.

Regarding the NBR, in which ”unconventional” instruments were not used, normalisation firstly involves an increase in the monetary policy interest rate, as well as an increase in the other interest rates agreed upon by the NBR in collaboration with commercial banks, in order to bring real^[9] interest rates of the economy to positive values. The recent decisions of the NBR to increase the monetary policy interest rate at 4.75% from 5.75% along with setting the deposit facility interest rate at 3.75% are to prepare the economy to escape from the area of negative interest rates while also facilitating the orderly convergence of interests to what is known as the “neutral rate of interest” – a theoretical equilibrium where there are no fluctuations as a result of monetary inflation. Secondly, normalisation requires maintaining a firm control on the liquidity assets of the banking system by establishing reserve requirements for credit institutions and by performing appropriate open market transactions for liabilities in lei and foreign currency.

In an uncertain context, normalisation must be done in line with the opportunity principle. This involves the pragmatic calibration of monetary policy measures according to available data and the most recent forecasts, as well as maintaining the NBR´s freedom in taking decisions insofar as an independent central bank, flexible monetary policy instruments used and a certain degree of security for economic actors sets the proper stage for a shift in the monetary policy with fewer risks.

The normalisation announced by NBR is far from becoming a restrictive monetary policy: the real interest rates applied by the commercial banks to their customers are still negative, especially for depositors. Should nominal interest rates approach the neutral rate, it is necessary to take into account whether or not the medium term inflation will surpass the 2.5%±1pp target; otherwise, the range of the neutral rate will be exceeded and a new, downright restrictive monetary policy, such the one that is taking shape in the US at the moment, will be instated. Due to the fact that in Romania the risk of perpetuating inflation is exclusively related to demand and the budget deficit, the NBR must follow the path of the Fed, the Bank of England and the ECB, although not to a great extent.

According to analysts, trying to fight inflation by making loans more expensive will most likely lead to a reduction in investments and a decrease in consumption; consequently, the NBR risks causing an economic recession. This dilemma, however, must be put into perspective: the prevailing scenario presented in the May 2022 “Inflation Report” starts from the assumption (which was also adopted in the official documents of the EU, IMF and World Bank) that Romania will experience positive economic growth in the 2022-2024 period, hence avoiding recession, unless a new energy shock occurs.

Under these conditions, the aim of the monetary policy should be restoring the normal conditions for economic activity. Moreover, an objective of the NBR is ensuring financial stability, a vital public good for citizens. A lasting inflation will lead to a decrease in public trust, increase in premium risk embedded in interest rates and price distortion, and thus to a slow rate of economic growth. 

4. The need for supply stimulation policies 

The obvious response to inflation is to reduce demand through monetary policy, unless the problem is with the supply chain. Supply stimulation policies consist of a set of measures which are meant to favour the production of goods and services. For example, mitigating vulnerability to external shocks with a broad range of energy providers or increasing the diversity and quality of skills available on the labour market leads to both an increase in domestic supply and the reduction of inflation. Thus, the problems of the double deficit Romania is facing (budget deficit and current account deficit) and others, such as unemployment, migration, falling purchasing power can be solved permanently.

On the other hand, demand-support policies (monetary and budgetary) are less relevant, as they tend to maintain inflation rather than reduce it; additionally, they no longer have the same room for manoeuvre as they used to. We specify that that the ”supply policies” addressed here focus on lasting transformations to increase the country´s productivity; it is not about reducing taxes and fees for businesses, whose effectiveness is arbitrary, but whose cost is certain. Of the necessary transformations, two are common across Europe: the ecological and digital transitions. A third transformation, however, is exclusive to Romania: carrying out structural reforms necessary for the transition from a planned economy to a market economy. 

5. Financing the transformations 

Achieving ecological, digital and structural transformations requires huge investments, which involves combining forms of financing from public and private funds. In terms of public investment, the NextGenerationEU programme is a decisive factor because it includes important measures aimed at accelerating the triple transition – green, digital and structural –as well as strengthening economic and social resilience. Besides, it is equally important to create and apply policies that favour a better allocation of private Romanian capital and foreign capital. Otherwise, Romania has numerous problems on this chapter due to excessive bureaucracy, on top of which an inefficient public administration is added along with an unpredictable legislative framework, which are affecting the business environment and limiting investment opportunities, especially for companies with Romanian capital.

These changes enable the consolidation of potential economic growth, but the pace of economic recovery will depend on the evolution of the new Covid-19 variants, hostilities in the region and the country´s capacity to absorb European funds. At any rate, in a difficult economic context related to the Russian war in Ukraine, the NBR did its job^[10] properly. By increasing the monetary policy interest rate and other interest rates applied to the commercial banking sector, it showed its determination to ensure price stability.

The general conclusion that emerges is that inflation must be reduced and it is possible to do so. First of all, this is accomplished through the normalisation of the monetary policy, which has already begun and must be continued in a decisive and organized manner. Secondly, there is the collective (Romanian and European) mobilization aimed at limiting energy dependence and accelerating ecological, digital and structural transition. Finally, long term policies focusing on increasing the productive capacity of the country help reduce inflation and improve economic growth, and thus are needed in order for the economy to become more sustainable, greener and fairer. Among these, the reform of the education and training systems must be a top priority so that it contributes to a greater extent to the increase of volume and quality of the labour force.

Romania certainly has opportunities, and if used adequately, the country will be able to overcome the cost of the current shock and continue to make social and economic progress. 

Notes:

[1] Potential growth is an estimate of the growth rate of the gross domestic product (GDP), assuming that the factors of production are optimally used and inflation is stable.

[2] Base money, also known as primary money, central bank money, fiat money, and high-powered money, is the money that the central bank creates solely on its own. In reality, it consists of money (cash, including coins and bills) and the amount that is now available in the current accounts that credit institutions (commercial banks) have opened with the central bank.

[3]S. Cerna, Monetary economy, West University Publishing House, Timișoara, 2007, p. 156-158.

[4]https://www.forbes.ro/sondaj-puterea-de-cumparare-a-scazut-cu-pana-la-50-271483.

[5] In statistics, distribution represents the possible values of a variable and the frequency with which they occur.

[6] Refers to the set of measures used by central banks in the situation where the conventional instruments traditionally used in monetary policy (i.e. direct interest rates, required reserves, open market operations) are inoperative. These measures were included in current bond purchase programs, preferential long-term financing operations, negative interest rates, “helicopter money” etc.

[7] The permanent and generalized downturn in the level of prices.

[8] The term refers to the cessation of the use of adoption of exceptional (sometimes also called unconventional) measures.

[9] The real interest rate represents the effective cost of credit. It influences the cost of living and is calculated by subtracting the observed or anticipated inflation rate from the nominal rate (the interest rate that is actually agreed upon and paid).

[10] https://www.contributors.ro/banca-nationala-a-facut-ce-trebuia-sa-faca/.