Money Matters, Romania’s case

This is my contribution to today’s seminar at the National Bank of Romania: Money Supply and Inflation.
My main conclusion is that much like the FED in the 30s the NBR misjudged the effect of the economic crisis and the stance of the economy and tighten monetary policy. The result was recession and short circuiting of the credit channel. I attribute the wrong assessment to too much reliance on the output gap and too many objectives besides stable prices – stable exchange rate and financial stability.

Should we save the RON?

In my last post I was arguing mostly from a theoretical point of view that Inflation Targeting has failed in Romania. To be fair it was never been given a fair chance. Two years into implementing the regime the NBR decided not target inflation but the exchange rate .  One perverse result from this in an economy with historically high inflation and no growth is dominance of local currency by ones from countries with economic growth and low inflation. In other words the central bank has implicitly subsidized the dominance of EUR by undermining RON.
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Recession was needed to control inflation, lower taxes are needed for growth

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.

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?