Annual inflation rate reached lowest level since 1999 in September 2011: 3.45%. The reactions range from overoptimistic to cautious. Expect the “independent” analysts near you to fill their clients’ mail boxes, newspapers and tv shows with various analysis of this event. I am sure that 99% of them will use the opportunity to revise downwards their inflation forecasts and from the career oriented ones will hear a lot about the contribution of different important people to this realization.
For me there are few questions that come to my mind looking at the data. First, how important is one point of data? Should I change my forecast? Finally, who do I send the chocolate box to?
I will start with the last question. This should be very simple, monetary policy has a mandate to keep inflation within a certain range. It is obvious then to look at the instrument used by monetary policy and see if, at least on a graph, there is a relationship with inflation. The first such relationship is depicted in the first graph. I do not know about you but this rudimentary analysis shows to me that before 2009 monetary policy was far behind the curve, throughout 2009 was a little too aggressive and in 2010 it gave up. The evolution of inflation since 2010 has no connection to the key policy rate. But…
… maybe there is something I am not seeing. I know the NBR is very innovative and maybe they approached this fight from a different angle: interbank rates. After all interbank rates should be the first leg in the transmission mechanism. So, I took average deposit rates on the interbank market and pit them against inflation and key rate (graph below). The conclusions remain the same until we reach 2010. Here rates look accommodating which could explain inflation remaining high after the VAT shock in July 2010. But they do not explain the dramatic fall in annual inflation rate in the last three months. Moving on…
NBR research has shown time and time again that exchange rate plays an important role as a monetary policy instrument. Let’s add the average monthly EURRON rate to the mix (graph below). We should expect to see EURRON appreciating when inflation is high and depreciating when inflation is low. Instead we see that the big jump in EURRON at the end of 2009 did not have any negative impact on inflation. Afterwards the exchange rate remained relatively flat while inflation jumped around like mountain goat on caffeine. In fact the latter part of 2011 shows a clear divergence between the two.
To be honest I am at a loss here. It does not look like monetary policy had a lot to do with inflation performance in the last three years. In fact my first post on this blog talked exactly about this: Monetary Policy Where Art Thou?. It would be too sad for a country to be left at the mercy of weather for both inflation and growth performance. Maybe it is just temporary and NBR will manage to keep inflation low and stable going forward.
But would I forecast that (2nd question)? Not today. Romania is a small open economy that due to its reliance, lately, on agriculture and industry has become very rigid. Thus any shock, positive or negative, has a bigger and longer lasting effect than in a more flexible economy based primarily on services. In fact looking at the last three years my best guess would be for inflation to climb back towards 6% in the next few months.
Finally, the first question: how important is this data point? Not at all. It can make for good newspapers title and fuel discussions between analysts and their clients. But the reality is that we have been here before: In march 2007 at 3.66% and in March 2010 at 4.2. We all know and saw what followed.
What it really matters is that average inflation rate since 2007 is at 6.17 while average target is at 3.56%.