Assessing Romanian monetary policy should be simple. The Inflation Targeting regime should be transparent enough that based on current and forecasted inflation one should be able to guess the future path of the interest rates. In the end this is what matters for an economy: the future price of money/debt.
I am saying it should be simple because within this monetary policy framework the central bank adjusts its policy instrument in response to deviations of forecasted inflation from an announced target. In practice it goes like this. The central bank agrees with the government/parliament the inflation target for the medium term (2 years). Then it uses its own model to forecast inflation for the same period. If the forecasted inflation is above the target the central bank needs to tighten monetary policy. Also, very important if the forecasted inflation is below the target the central bank needs to loosen monetary policy.
To tighten/loosen monetary conditions in the economy central banks have different instruments. In essence what the central bank does is to inject or withdraw money from the economy. The effect visible to the public is that interest rates –price of money/debt – increase when monetary policy is tighten and decrease when it is loosen.
Back to real world, how do we see these developments in Romania? Based on theory we should observe a long run relationship between the key policy rate and inflation. But this does not exist, especially for the last 4 years.
We could try to see if the relationship exists with money market rates, but as the next graph shows, again no relationship.
Maybe we can find a relationship between monetary base and inflation? No luck here either.
All of these figures show that the central bank does not care about inflation too much. If we put this in a very simple equation it would look like this: MPI = α + β (FINF – TINF) + ε
MPI = monetary policy instrument, FINF = forecasted inflation, TINF = target inflation
Therefore, based only on the previous graphs the value of β ≈ 0, or there is almost no identifiable relationship between the monetary policy instrument and inflation.
Nevertheless, we still would like to know what might happen with interest rates in 2012 in Romania. My first conclusion is that you should not look at falling inflation to bring lower interest rates. In fact I think inflation will fall much lower than NBR’s forecast. The next graph show the inflation forecast or the entire policy horizon of NBR and my own (FC).
All hope is not lost though. There is a long run stable relationship which tells us about the interests of the monetary policy in Romania: monetary base and the exchange rate. As you can see, the central bank is adjusting monetary base to control volatility in the exchange rate. The relationship is clear before 2008, although the exchange rate responds with a lag, and it is almost perfect after that when central bank used FX interventions to control exchange rate volatility.
How does it work? It is quite simple. Instead of the equation above central bank has a policy rule that looks like this:
MPI = α + β (FINF – TINF) + γ (AER-TER) + ε
In this equation we now know that the MPI is the monetary base while AER = Actual exchange rate and TER = target exchange rate.
As you can see I do not think that NBR does not care about inflation directly but I as you can see from the graph and soon from my research paper it responds much more to deviations of the exchange rate from a target than to inflation deviations. The main problem here is that while the target for inflation is known the exchange rate target is not. However, it can be estimated and I show that in my paper. Also, the paper will show that this way of conducting monetary policy leads to higher volatility in inflation and GDP .
I expect inflation to surprise on the downside in 2012. However, this development will not be followed by lower interest rates from the NBR.
As I said previously the exchange rate will be allowed to depreciate throughout 2012 towards a EURRON rate of 4.5. As this depreciation should be mostly the result of trade deficit and capital withdraw it will be controlled NBR by keeping monetary base constant or even lower. Thus, there is little hope for lower interest rates in 2012. In fact as situation in EU deteriorates the scenario of interest rates increasing has a higher probability.
Bottom line, 2012 will bring record low inflation in Romania, interest rates will remain high or even increasing and the exchange rate will continue to slide towards the EURRON 4.5 rate.