Nicolaie Alexandru-Chidesciuc of ING -
We expect Romania's central bank (NBR) to hike by 75 basis points to 8.75% on February 4. Still, even a hike of 100 bps is highly possible because of the brisk exchange rate depreciation and the outlook downgrade by Fitch to 'negative' from 'stable'.
No such thing as a free lunch
The monetary policy stance loosened even after the 50-bp hike on January 7, so the NBR Board will be re-assessing the necessary measures to restore some monetary policy restrictiveness. The message policymakers send to the public will be very important after inflation missed the 2007 target and already looks unlikely to reach this year's target. Other topics could include:
1) How to deal with eventual second-round effects stemming from the impact of supply-side shocks on inflation expectations.
2) How high might the EUR/RON exchange rate go and is the NBR capable of stopping it through eventual forex interventions and without significant rate hikes.
3) The increasing inflationary pressures at the global level, against a background of loose fiscal and wage policies in an election year.
Headline inflation came in at 6.6% on year, significantly overshooting even the upper limit of the tolerance band (3-5%) around the NBR's central target. The central bank has missed the inflation target for the second time in three years and its credibility would be strongly affected by another failure to meet the target at the end of 2008, even though the NBR's eventual appeal to escape clauses would be justified for the 2007 inflation target.
The justification for missing the inflation target could come from the fact that a considerable part of the increase was caused by supply-side factors (higher food and oil prices). Nevertheless, the exchange rate depreciation and persistent excess demand also drove up prices. The central bank should remain worried as the CORE3 measure of inflation climbed further reaching 5.5% on year at year-end. Moreover, recent data support our view that inflationary pressures coming from excess demand should not be ignored, alongside supply-side shocks.
Considerable hikes in the key policy rate (significantly above 9%) would be required to stop the leu depreciation and to bring inflation inside the tolerance band before end- 2008. That would imply accepting a fast and strong appreciation of the domestic currency (as the exchange rate channel is the most effective channel of the monetary policy transmission mechanism). However, the NBR expressed concerns about the unsustainable levels the exchange rate reached during the summer and we think it is very unlikely it will force the currency to appreciate since the external imbalances have not been tackled. Consequently, we do not see the NBR embarking on a strong exchange rate policy. As such, there is a high probability that the year-end inflation target will be missed once again. Actually, we expect that the new Inflation Report, which should be published after the rate-setting meeting, will show inflation outside the target band. We base this conclusion on our inflation forecast which is above the upper limit of the target band and on a recent statement from Governor Isarescu saying that the NBR "hopes to bring inflation inside the tolerance band at the end of 2008 or at the beginning of 2009".
We think that it is preferable at this moment for the Romanian economy to have a EUR/RON exchange rate above the equilibrium level as it is required to correct the external imbalance. However, the same depreciated exchange rate puts upward pressure on inflation and also makes the current monetary policy stance loose. The dilemma that the NBR faces is quite complex, as a decision to hike rates to a level consistent with bringing inflation in line with the target could have some undesired effects. One of them is a re-orientation of economic agents towards foreign-currency denominated loans, as the exchange rate would re-embark on an appreciation trend (because only an appreciating leu could help contain inflation). Another is related to the implications of nominal exchange rate appreciation at a speed exceeding that consistent with fundamentals. This would reignite the NBR's worries about a possible future reversal of the exchange rate's trend and the impact on future inflation. Recent experience proves that such a reversal would strongly impact inflation.
Moreover, an appreciating exchange rate would lead to a pronounced widening of the current account deficit (above our current forecast of 15.1% of GDP for 2008). There are two ways through which rising imbalances could be corrected. The first and the hardest for the Romanian economy could be brought by market forces. A painful adjustment of the current account deficit would lead to a significant depreciation of the exchange rate and a hard landing for the economy. The other way is by an appropriate mix of economic policies: monetary, fiscal and wage policies. However, the second solution is hard to imagine in an election year. The most likely scenario is, consequently, the adoption of certain measures by the NBR that will not solve the fundamental issues, but will, likely, allow a soft landing. This is partly understandable as, usually, every central bank tries to avoid inducing shocks into the economy, but it comes at the high cost of increased uncertainty regarding future the development of the Romanian economy. This uncertainty mainly translates into a volatile exchange rate and volatile inflation.
Nicolaie Alexandru-Chidesciuc is senior economist at ING in Bucharest
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