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Political Uncertainty and Inflation

Political Uncertainty and Inflation

Recent political events in Romania (the removal of some ministers, the dissolution of the ruling coalition, the dismissal of the government by a motion of no confidence etc.) created a great deal of uncertainty regarding fiscal, monetary and legislative policy. The measures promised or claimed by politicians in response to the powerful impact of the energy crisis on the Romanian economy and society, which have already been affected by the COVID-19 pandemic, increase this uncertainty. In particular, uncertainty concerns the nature, magnitude, and timing of financial support measures for the population and businesses, the monetary policy measures projected by the National Bank for the inflation slowdown, absorption of EU funds, sustainability of public debt etc. Many public voices, from journalists to analysts of credit rating agencies and international financial institutions, warned that this uncertainty about the conduct of economic policy is affecting the behavior of businesses and the population in terms of production and consumption expenditure, investments, new jobs creation etc.

Economic theory has long provided elaborate analyses of the channels through which the effects of uncertainty are conveyed to the economy: irreversible investments, savings made for precautionary reasons, financial frictions etc. In recent times, characterized by the rise of political uncertainty because of circumstances ranging from suspicions about China’s currency manipulation to Brexit, more and more economists are using the elements of public choice theory and game theory to better understand why certain countries choose specific macroeconomic policies at certain times. Combining these analyses with the results of much empirical research carried out recently, the latest economic literature proposes several techniques for measuring political uncertainty and its economic effects, through which it reveals how these mechanisms work and how important they are in different countries and periods.

Within this framework, the analysis of the relationship between political uncertainty and the effectiveness of monetary policy aimed at inflation control shows that an increase in uncertainty leads to an economic activity slowdown and an increase in the long-term expected inflation rate. Moreover, the uncertainty regarding economic policy has negative effects on the time structure of expected inflation rates. Therefore, in response to uncertainty shocks, the expected short-term inflation rate is decreasing while the long-term expected inflation rate is increasing. This shows that the effects that expectations on inflation are having on actual inflation are contradictory and ambiguous. This is explained by the fact that there are at least two transmission channels of the influence of inflation expectations on actual inflation, i.e. economy liability, and the strength of the foundation on which the expectations are based (e.g. announcements by the central bank on the inflation target). Recent events in Romania show that the latter channel is unstable and short-lived. 

Central banks have also been found to be decreasing their interest rates in response to the temporary increase in uncertainty to offset the negative effects of this shock on the economy. They are also concerned about keeping long-term inflation expectations firmly anchored (at a level consistent with their inflation target), considering that this itself is a response to temporary economic shocks.

Hence, central banks face a difficult choice between stabilizing short-term inflation expectations on the one hand and stabilizing long-term expectations on the other. This outcome shows that to stabilize the economy, the central bank pays a certain price, namely the loss of the anchor of long-term inflation expectations.

Although the commitment of central banks to keep inflation low and stable remains unchanged, a strong uncertainty about economic policy leads businesses to believe that central banks are not able to achieve their goals. This is also a threat to the National Bank of Romania, given the current crises, the problems created by the actual and expected significant budget deficits for the foreseeable future, and the repeated unfounded and reckless accusations of politicians against the central bank.

The fact that in the last decade the inflation rate has been much lower compared to other periods of the post-communist era, and the inflation expectations have also been much more optimistic, does not seem to eliminate, therefore, the danger that uncertainty about the economic policy will lead to the loss of the anchor of inflation expectations and, consequently, to the weakening of the National Bank’s credibility.

Thus, the credibility enjoyed by the central bank in the eyes of the public is particularly important for the success of the monetary policy, without resorting to excessive interest rate increases and the restrictive use of other monetary policy instruments. This credibility is reduced by uncertainty about the direction of economic policy and the details of its implementation, the effectiveness of this policy, and the determination of the authorities' commitment to their future policies. Nevertheless, uncertainty can be diminished by clearly communicating the measures that authorities can take, publishing their information, responding quickly to challenges, and ensuring the long-term coherence of their policy.



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The Romanian-American Foundation for the Promotion of Education and Culture (RAFPEC)

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