Almost all central banks use the output gap model to explain the inflation process. They also use to the model to forecast inflation. Romanian National Bank is not an exception. The graph below is put together using data from the Inflation reports. It shows end of year annual inflation relative to the NBR’s calculation of the output gap. The grey area represents the recession period and the vertical splits the data into real and estimated.
For those not familiar with the concept the output gap is a statistical estimation of the difference between potential GDP and actual GDP. Positive values mean the economy is growing above potential while negative values show the economy is below potential. Therefore, when the economy is growing above potential in theory it means that resources in the economy are fully utilized and there is a higher probability that prices will rise due to higher costs. The opposite is expected – lower inflation – for an economy below potential.
I do not believe in this model. The output gap hides if the potential GDP is at 6%, 1 % or -3% and in the end is just an estimate without any theory to back it up. Still, I think in extreme cases it can show you something. From the graph below, it is obvious that it took Romania a prolonged period of recession and years of muddling through below potential GDP to bring inflation down to reach the target of 3% for 2011.
However, going forward, things are not so simple. In the absence of oil price shocks or tax shocks I think the biggest risk for Romania is deflation. It will be interesting to see how the Romanian economy will cope as real rates will increase due to the surprise drop in prices. The immediate result in my view will be zero growth or even recession.
To counter this I hope NBR will not go crazy and try to push inflation up to keep real rates low. There is a better solution: lower taxes. A policy of lowering taxes and commitment to cut public expenditures will help private aggregate demand and investment increase. In the end it is a healthier and more sustainable way to navigate through the muddy and troubled waters of the following period.
For those not familiar with the Romanian economy, the chart below shows the recent progress of this variable relative to three other countries in the region.
Finally, is good to remain humble and focused as it will take some time for inflationary expectations to be modified in Romania. As you can see in the last 12 months average annual inflation in Romania was almost double than inflation in other countries in the region.