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In many countries, including Romania, the prices of goods and services tend to rise. This process is called inflation.

Prices are determined by many factors: supply and demand, the cost of labour and raw materials, competition among sellers, and so on. But, in essence, inflation is related to supply and demand: if the demand for goods and services increases faster than the supply, prices tend to rise.

Inflation is measured by the consumer price index (CPI), which represents the average increase in the prices of goods and services included in a representative list, called a basket. The content of this basket is determined according to the quantities of goods and services that people usually buy.

Thus, the National Institute of Statistics of Romania publishes a monthly CPI calculated on the basis of a nomenclature of goods and services structured into 54 food items, 112 non-food items, and 48 service items, all significant for population consumption.

The institute also publishes several types of inflation rates, expressed as ratios (percentages) between the price index of the reference period and that of the base period: the monthly inflation rate, the average monthly inflation rate, the annual inflation rate, and the average annual inflation rate.

The EU statistical office, Eurostat, publishes the Harmonized Index of Consumer Prices (HICP), calculated based on a common classification of consumer expenditure and a single set of definitions. The HICP is mainly designed to assess price stability in the euro area and the convergence of price developments within the EU, but it is also used for comparisons of inflation at European and global levels.

These indices are averages that express, in general terms, the main trend of price developments. However, the population perceives inflation differently, depending on the specific combination of goods and services they frequently buy. For example, if the price of gasoline increases, those most affected are obviously people who own cars, while those who do not are less affected. Similarly, if the price of bread increases faster than that of potatoes, people who consume more bread are more affected by inflation than those who consume more potatoes.

The CPI is not the only measure of inflation, but it is the most widely used, both by businesses and by public institutions and governments. A persistent increase in the CPI erodes the real value of wages, scholarships, pensions, and other fixed incomes.

Stable and predictable inflation indicates that the economy is functioning normally. For instance, when a company prepares its budget for the next year, it must estimate how much the costs of equipment, consumables, rent, and salaries will increase. If these costs rise, the company will likely raise its own prices as well.

High inflation reduces the purchasing power of the population—that is, its ability to buy goods and services with the income earned from wages, pensions, scholarships, rents, or interest. Therefore, a rapid increase in prices disrupts the normal functioning of the economy: people buy fewer goods and services, and economic activity slows down.

Moreover, those who have savings discover that they can purchase fewer goods and services than they expected when they set money aside. As a result, consumers and producers seek ways to protect themselves from the effects of price increases—for instance, by substituting necessary goods or services with cheaper alternatives, or by purchasing them less frequently.

In extreme cases, very high inflation signals that the economy is adrift. For example, in Venezuela, political instability and poor economic management have led to an inflation rate of about 400%. Such inflation is called hyperinflation by economists.

In Romania, inflation is currently the highest in the EU: the inflation rate rose in August this year to 9.9%, up from nearly 8% the previous month, and forecasts estimate an inflation rate between 9% and 10% by the end of 2025.

Although high inflation is undesirable, deflation—that is, a general decrease in prices—is no less harmful. When the prices of goods or services fall, demand and production initially increase. However, a generalized and persistent decline in prices usually reflects deep economic problems.

For example, if people lose their jobs, they consume less; businesses sell fewer goods and therefore reduce prices. Consequently, consumers hesitate to buy larger quantities, hoping prices will continue to fall. But if people refrain from consumption—that is, increase their savings—they spend less on current purchases of goods and services. This in turn causes prices to fall further, slowing down economic activity.

In August 2005, the National Bank of Romania (NBR) adopted a monetary policy strategy called direct inflation targeting. The inflation target set at that time was relatively high: 7.5% ±1 percentage point. However, in the following years, significant progress was made in disinflation, and the NBR’s ability to manage inflation expectations improved substantially.

Unlike the 1990s, when Romania experienced hyperinflation, in the following period the population paid little attention to inflation, as the NBR gradually reduced its targets. Between 2012 and 2020, inflation remained close to the target.

However, in 2022, the inflation rate increased to 13.8%, although the target was 2.5% ±1 percentage point. One cause was the reopening of the economy after the COVID-19 pandemic, which increased demand for goods and services. Other causes included disruptions in global supply chains (in which Romania is deeply integrated) and the economic consequences of the war in Ukraine.

To these factors was added the relaxed fiscal policy of successive governments after 2014, which further boosted solvent demand and, therefore, inflation. As a result, a large share of the population—especially people with fixed incomes—has been facing increasing economic difficulties.

To curb inflation, the NBR raised the monetary policy interest rate (the interest rate at which credit institutions borrow from the central bank) from 5.5% in August 2022 to 6.25% in October 2022, 6.75% in November 2022, and 7% in January 2023. It subsequently reduced this rate slightly—to 6.75% in July 2024 and 6.5% in August 2024—and has kept it unchanged since then.

The strategy has not worked as intended: inflation has continued to rise, and the economy risks entering stagflation. This phenomenon—which we have analysed extensively in a previous article—shows that inflation is very dangerous and must be maintained at a low, stable, and predictable level.

In the case of the NBR, the monetary policy interest rate applies to operations it carries out on the money (interbank) market: repo operations (purchases of assets from credit institutions with a commitment to repurchase them later at a predetermined price), attracting deposits from credit institutions, granting loans, and so on.

An increase in the policy rate encourages banks and financial institutions to raise interest rates on deposits, mortgages, and other loans. However, higher interest rates tend to slow the growth of demand, encouraging people to save rather than borrow and spend. Firms then respond by slowing the pace of price increases—or even lowering prices—to stimulate demand. As a result, inflation decreases.

Conversely, reducing the policy rate has the opposite effect and helps stimulate demand and economic activity.

Of course, the central bank does not intervene every time prices change. Instead, it focuses on large and sustained price movements that could push inflation away from the target. This approach is justified by the fact that the effects of changes in the policy rate take time to appear in other interest rates, consumer spending, and prices.

Inflation targeting—and this is its key condition for success—is effective when people behave in ways that support the convergence of observed inflation toward the central bank’s target. Indeed, if the population expects prices to increase by about 2.5% per year on average, employers and employees are more likely to agree on a 2.5% wage increase to compensate for the rising cost of living.

Because wages are directly related to the costs of producing goods and providing services—and these costs influence all prices—such behaviour supports the achievement of the central bank’s inflation target.

Photo source: PxHere.com.