Alternative view of falling inflation in Romania

Starting with August this year NBR is forecasting lower and lower inflation. The latest forecast puts inflation at 1.9% in 1Q2012, at 2.3% in 2Q2012 and at 2.8% in 2013. During this period inflation reaches 3.8% in 3Q2012 and then stabilizes around 3%. Everyone in Romania should celebrate these numbers. Before we bring out the champagne I have two question.
What happened to the Ballasa-Samuelson effect?
Could the 50% cut in potential GDP explain these inflation numbers?
I have always been a strong advocate of low inflation and stable inflation. It is my belief that inflation distorts economic decision and hampers growth. That is why I favor a flexible inflation targeting regime.
Of course I am not alone in my beliefs as low and stable inflation is the objective, at least on paper, for all central banks. This includes the NBR. To take matters further, NBR adopted the inflation targeting regime in 2005. Unfortunately the track record does not show that NBR is a real inflation targeter/fighter. One reason put forwards by the central bank’s specialists and friends was the Balassa-Samuelson effect.
In very simple words the B-S theory tries to identify the implications of different productivity levels between two countries. In this theory the economy is separated into two main areas: one producing goods and services that get traded internationally (cars, tourism etc.), tradables, the other producing goods and services for the domestic market only (restaurants, car repair shop, plum brandy 🙂 ), non-tradables. The tradable part is in competition with goods from all over the world and thus needs to increase productivity. This means that it has to attract better skilled labor and thus has to have wages comparable to those in other countries. In Romania the wages of people working for Dacia for example should converge to those working for the companies competing with Dacia. Now this is where the B-S effect kicks in as the rest of the economy, non-tradable part, has to increase wages not to lose labor to the tradable part. Thus, an open and poorer economy will have to deal with structural higher prices until its overall costs reach the level of the richer countries.
Back to the real world, the B-S effect has been put forward as a reason for what it seemed perpetually high inflation in Romania. To prove the point there were research papers trying to put a number on the effect. One such paper is written by Ionut Dumitru and Ioana Jianu (Dumitru). This from the abstract:
“Due to the Balassa-Samuelson effect, the candidate countries to the European Monetary Union face a possible conflict between the effects of tradable productivity increase on inflation and on the appreciation of the real exchange rate on one hand, and the Maastricht criteria regarding inflation and exchange rate stability on the other hand. A restrictive monetary policy could succeed in reaching inflation criteria, but only with the cost of slowing down real convergence…., the impact of Balassa-Samuelson on inflation could have been on average 2.46%. Therefore, the Balassa-Samuelson effect is expected to result into higher inflation with future price liberalization for non-tradables.”
As you can see the paper does not advice for tighter monetary policy as it would come at a real big cost for the real economy. Even more interesting the B-S effect is calculated for that sample to be around 2.46%.
Assuming the authors are right, similar estimates came from the NBR, what are the implications for today’s inflation numbers? Is inflation in Romania only 1%? If the central bank pushes inflation to 1.9% in 1Q2011 does it mean it went too far and we actually have deflation?
In fact what I am asking is what happened to the B-S effect? My guess is that if there was ever one, now it has vanished. What is strange is that exports have had a big contribution to GDP growth in 2011. However, the pressure on wages from that sector to the rest of the economy is not felt as it was in the period prior to 2008. The disappearance of B-S shows a weaker economy. Even more the B-S effect was believed to be present and significant due to the nominal convergence of the Romanian economy to the richest EU members.
In the absence of a B-S inflation can fall but it shows that the economy is also falling. AndTO support this view here is one more piece of evidence: recent estimates of the potential GDP for Romania. This is, again, a theoretical concept which conveys to the public that as long as the economy grows around the potential level inflation cannot be a threat. In 2008 NBR was estimating that number to be 6% today it puts it somewhere between 2% and 3%. Under those conditions it should not be a surprise that prices are falling.
Low and stable inflation is what and economy needs for growth. Romania is achieving low inflation right now, although I am not sure it is stable. However, it is not the central bank that should be congratulated. It is the real economy. The combination of global crisis and inappropriately tight monetary conditions have pushed Romanian economy onto a diverging path from richer EU members – absence of B-S effect – and halved the potential GDP. This is the real cost of the low inflation in Romania.