I admit NBR surprised me today. I did not think it had the balls but most of it I thought it cared more about the real economy than about the political shenanigans. The only immediate effect of today’s decision is an instant 25bp profit for local banks financing the Romanian government debt. Of course, there is hope from the NBR that such a favor will be returned and local banks will continue to fund the increasing local debt at a lower rate. As this all happens at very short maturities the effect for all of us is that we will have to pay for it through higher taxes in the future.
The decision from the NBR theoretically should only be judged relative to the deviation of inflation forecast from target. The graph below shows NBR’s view of how inflation will deviate from target in the following 8 quarters. However, inflation has surprised positively – lower than expected – since these estimates were made. Thus, theoretically NBR is adjusting monetary conditions by taking into account the most recent information to make sure inflation will be at target, 3% in 8 quarters from now.
This is the theory. One major assumption here is that there is a relationship between the key policy rate and inflation over the forecasting horizon. Unfortunately this is not true (see my Monetary Policy in 2012).
What should happen when NBR lowers the key rate?
It depends on the instrument. In very simple terms NBR uses few instruments to control short term liquidity in the money market. From there it expects the market, i.e. banks, to do the job of transmitting the effects of monetary policy decisions to the real economy. In theory, a lower key policy rate should mean a more relaxed monetary policy. The immediate effect should be seen in the money market. This is where the problems arise for the NBR. But as you can see in the graph below after NBR lowered the key rate from 6.25% to 6% on November 2nd 2011 monetary conditions in the money market have gotten worse not better. The available average liquidity has in fact decreased and so did the number of transactions.
Furthermore for those expecting lower lending rates, via the credit channel, evidence shows that ROBOR rates used as benchmark for pricing loans have actually jumped and remained high right after NBR lowered the key policy rate on November 2nd 2011.
These graphs show that there is a break down between theory and practice when it comes to implementing monetary policy in Romania. Just by lowering the key rate does not mean that monetary policy is now loose. There are 2 main reasons for this:
1) NBR’s is managing short term liquidity to control RON volatility
2) Related to first, NBR unsterilized interventions create too much volatility in the money market with the risk that at some point banks will have to use the LOMBARD facility, currently at 9.75%, to finance themselves. (See graph below)
Nevertheless, someone will profit from a lower key policy rate. In the first instance banks and then Romanian Government. The banking sector is financing the Government deficit at short maturities at rates around 7%. From next week, they will finance those “investments” at 5.75% instead of 6%. It does not seem a lot but when we talk of billions of RON it adds up. Of course the expectation is that some of those profits will be passed on to the Government via lower interest rates for the public debt.
So, the banks win and the government wins. In this environment do you see a reason for the government to cut expenditures or for banks to lend to the real economy? I do not.
Today’s interest rate decision looks great on paper and in accordance with Inflation Targeting theory. Unfortunately, in Romania the NBR does not target inflation, at least directly. Also, the key policy rate is irrelevant when the real cost of short term funds can go from 1.75% to 9.7% within few days.
Finally, what good is playing with the RON rate when the economy, including the government, is borrowing and making contracts in EUR?
P.S. My advice is that if you want to know what happens to the short term funding cost watch the EURRON. Also, if NBR is serious about making RON lending a competitor to EUR lending then it has to make RON cheap. This means lower RMO for RON and some more depreciation. In the same time it has to make EURO expensive. The best way to make EURO expensive in Romania is to show that it carries risk, FX risk.
Source for graphs: NBR
Related Post: NBR’s November 2011 decision