Like all central banks the NBR uses for its forecasting round a macro-model that is built around the three equation New-Keynesian model. In this model the central bank instrument tries to minimize deviations of inflation from a target and of GDP from potential (eliminate the output gap).
Nevertheless, if we look at the NBR’s behavior the reaction function will also include response to the exchange rate deviations from a target. Only the inflation target is known to the public. The output gap is presented afterwards (never the potential GDP) and the exchange rate target is never known by the public.
In October 2008 the NBR responded to what it believed to be a speculative attack on the domestic currency by lower money supply via direct foreign exchange interventions and capital controls (see Deconstructing the myth of a speculative attack). As a result interest rates increased to 100% on the money market and 1000% on the FX SWAP market. The credit channel was destroyed and the economy entered the longest recession after the 1990.
At the time I was working on the trading floor o an international bank in Romania. I expected the central bank to slowdown the depreciation of the currency via interventions but I never expected that the central bank would not sterilize those interventions – sell euro for lei and then introduce lei via other instruments in the money market so the liquidity would not be affected. In my last TV appearance I warned that further unsterilized interventions would drive the economy into deep recession. Few days later I was banned from public appearances and the banking sector was raided by the Competition Council (the investigation has ended since then with no wrong-doings by the banks).
Why did the central bank react this way? Besides political reasons there is an explanation that comes from the way the central bank models the economy. In August 2008 the central bank expected the output gap (potential -real gdp) to become negative in 2010. However in November 2008, after the Lehman Brothers and with double digit interest rates in the money market and for loans, the NBR DID NOT expect a negative output gap at all. At that time was estimating the output gap to remain positive and real GDP to move above potential. In this conditions the macro -models would call for a TIGHTENING of monetary policy which is exactly what the central bank did. Looking at the following estimates we see that this “built in” bias in the NBR macro-model has not been eliminated as estimates of the output gap were always more optimistic than in reality.