Gala BURSA 2018

Does the National Bank of Romania still have a monetary policy strategy?

Călin Rechea (translated by Cosmin Ghidoveanu)
English Section /

This type of monetary policy has been adopted by numerous developed or emerging countries starting with 1990, starting from the premise that a monetary policy based on transparent rules, despite the independence of central banks, can ensure even better price stability than a discretionary monetary policy.

An analysis by the IMF, discussing the current stage of inflation targeting globally ("Inflation Targeting: Holding the Line", July 2017), states that "the empirical evidence concerning the performance of inflation targeting supports, although not entirely, the effectiveness of this environment for obtaining low inflation, the reduction in the volatility of inflation and the tethering of inflationary expectations".

The NBR adopted inflation targeting in August 2005, and at the time it said that "the other requirements and criteria which are prerequisites for the efficiency of this strategy have also been met".

These include the drop of the annual inflation rate below 10%, the accumulation and consolidation of a credibility gain by the central bank, the strengthening of the de jure and de facto independence of the NBR and the restraining of the fiscal dominance (author's note: the term defines the economic condition which occurs amid high government debt and high budget deficits, which force the central bank to keep the interest rates low to avoid sovereign default).

Other requirements met were the strengthening of the banking system and the relative increase of financial intermediation, the increase in the transparency and responsibility of the central bank, the increase in the flexibility of the exchange rate and the reduction of the economy's vulnerability to its fluctuations.

The last place on the list presented by the NBR was held by a very important criterion for the success of inflation targeting, respectively "the clearer shaping of the macroeconomic behaviors and of the mechanisms for the functioning of the economy needed for the identification and increase of the monetary transmission channels".

Unfortunately, the degree of carrying out these criteria and requirements has decreased considerably over the last ten years and raises significant doubts not just over the efficiency of the strategy, but its very reason to exist.

According to official data, inflation volatility has been high over the last few years, amid a downward trend, but that too has seen a violent reversal of more than a year.

In this context, it is hard to talk about the effectiveness of inflation targeting as far as the reduction of the volatility of consumer prices is concerned.

If the inflation targeting has been adopted as a monetary policy strategy, the direct implication is that the National Bank of Romania has available and will use various instruments to control the rise of prices.

The most important instrument is the policy rate, which, beyond its incompatibility with a free market economy, should have a proactive, rather than reactive nature, to reduce price volatility.

So why then, are all kinds of excuses found every time for missing the inflation target, when its very existence assumes that the price dynamic can be "controlled"?

The latest report on inflation from the NBR includes statements such as "the acceleration of the annual rate of inflation is determined by components of the consumer basket which are outside the area of effect of the monetary policy".

But there are always "exogenous components", whose influence should be taken into account to reach the inflation target, because we are not living in a determinist universe.

The IMF analysis also shows that aside from the explicit announcing of the inflation target, which in Romania is 2.5% with a fluctuation interval of one percentage point, the strategy of inflation targeting also involves "communicating to the public clearly and unambiguously, that reaching the target takes precedence over the other objectives of the monetary policy".

In the case of the NBR, the divergence between statements and facts doesn't seem to indicate that the inflation target is a priority for the monetary policy. If it were, the rise of the policy rate would have begun earlier, in order to avoid major "leaps" amid the accelerated increase in inflation.

A relatively simple calculation, based on the rule presented by professor John B. Taylor in a 1993 article, shows that the monetary policy of the NBR should currently be at approximately 9%, amid an inflation rate which far exceeds the target and a significant positive difference between the current GDP and the potential GDP.

According to a modified Taylor rule, in which one of the variables is the difference between the unemployment rate and the balance unemployment rate, the monetary policy rate in Romania should be approximately 7%.

In keeping with transparency, which should characterize the inflation targeting framework for all central banks, Federal Reserve Bank of Atlanta publishes quarterly the value of the monetary policy rate, resulting from the application of an adjusted Taylor rule.

According to this rule, the latest data in Romania concerning the inflation rate and the difference between the real GDP and the potential GDP, shows that the monetary policy rate should be 4.5%. The current value of the policy rate, of 2.25%, should have been announced since Q1 T1 2017.

Why aren't measures being taken? Because the National Bank of Romania, even if it is independent de jure, is no longer independent de facto and is no longer pursuing inflation targeting.

Is something like that possible? Of course, and the confirmation seems to be coming from a strategy consultant from the NBR, which recently published an article on the website, which attempts to show that "the monetary policy can keep inflation in check if it is well understood" (author's note: see the article "The monetary policy can keep inflation in check if it is well understood", author Daniel Oanţă, March 14, 2018).

The article focuses first of all on minimizing the impact of some statements made by governor Mugur Isărescu about the inflationary expectations of the population and companies, but also includes a statement which has a great potential to undermine the stated monetary policy strategy.

Amid the current debates concerning the capping of interest rates on loans granted to the population, the author claims that "tying the cost of loans across the entire economy, to the monetary policy rate, which is decided in a discretionary manner and is not one of the market, is not just a strategic error and a nonsense which can slow down the economic growth, but also an undermining of the most powerful instrument that a central bank has available".

So he says that the policy rate is "decided in a discretionary manner", rather than according to transparent rules, based on which the inflationary expectations are also formed?

It is true that the strategy for inflation targeting also leaves room for discretionary decisions of the central bank. In the analysis from the IMF it is also written that "a major advantage of inflation targeting is that of combining rules and the discretionary aspect", and this strategy is considered to be one characterized by the "restrained arbitrariness", which include two distinct elements: "a precise medium term inflation target and the possibility of reacting to the short term economic shocks".

Isn't there quite a gap between the restrained discretionary behavior and the discretionary decision when it comes to the monetary policy, especially when statements of some officials of the major central banks show a complete ignorance when it comes to the level of the intervention interest rate, as well as of the inflationary mechanisms?

The most important element which supports the statement that the NBR is no longer independent de facto and no longer seeks inflation targeting is the expansion of the fiscal dominance, i.e. the existence of a significant government debt and of the large budget deficits, which force the central bank to keep the interest rates low to avoid the sovereign default.

One of those guilty for this situation is the NBR itself, which, through its ultralax policies of the last few years, has "stimulated" not just the government's appetite for borrowing, but also the appetite of the population for loans, especially when something like the "First Home" program exists.

The NBR is not the only central bank that has "forgotten" its inflation targeting strategy in the years that have followed the beginning of the global financial crisis.

The Central Bank of Australia (RBA), which has adopted inflation targeting in 1993, has recently justified its keeping of the monetary policy at a historic low of 1.5% by "taking into consideration the high level of debt of the population", population which "has taken advantage of the low interest rates to speculate on the real estate market", according to Reuters.

The situation is similar in the United States as well. Bill Gross, portfolio manager at Janus Capital Group, recently wrote that "the global economies are far too indebted to deal with the aggressive hiking of the interest rates by the Federal Reserve". In Gross' opinion, the policy rate of the American central bank cannot exceed 2% given an inflation rate of 2%, meaning a real interest rate of 0%.

In autumn last year, the same Bill Gross was saying that "we now have false markets", because "the financial markets are artificially compressed and capitalism is distorted because of the monetary policy of the Fed".

If we keep things in proportion, the same can be said about the domestic "capitalism", even though the truth would be rather along the lines of "during the almost 30 years of < < transition > > it has almost not existed at all".

Faced with the economic commission of the Senate, the only thing governor Isărescu could do would be to use a famous line from the movie "A Few Good Men". "You want the truth? You can't handle the truth!", like Jack Nicholson's character was saying before his Court Martial.

Unfortunately, the members of parliament and the citizens are not the only ones who can't handle the truth. The National Bank of Romania can't handle it, because it doesn't understand or doesn't want to understand how an economy "tortured" by irresponsible policies "works".

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