Mugur Isărescu: Transition - how to secure a stronger economic future
for the constituency?
Speech by Mr Mugur Isărescu, Governor of the National Bank of Romania, in the panel on
"Transition: How to Secure a Stronger Economic Future for the Constituency?", during the
annual meeting of the IMF and World Bank Constituency, Kyiv, Ukraine, 4 June 2016.
* * *
Ladies and Gentlemen,
In my address I would like to focus on the challenges in conducting monetary policy in a way
that will contribute to securing a stronger economic future for countries in our constituency.
Obviously, my account is shaped by Romania's experience, but I hope it will still keep you
interested, as it may be relevant for other small to medium-sized emerging economies.
1. Brief account of monetary policy regimes in Romania
At the time when the National Bank of Romania had to choose a strategy for conducting its
monetary policy, i.e. in the early nineties, monetary targeting was actually the only feasible
option. Not only did the low forex reserves preclude a fixed exchange rate arrangement, but,
even if possible, the alternative was not suitable given the widening external imbalance.
However, by the end of the decade, monetary targeting had reached its operational limits
given the break in the relation between monetary aggregates and inflation, a phenomenon
which matched developments elsewhere in the world.
At that point, we took into account pegging the exchange rate, but neither the hard nor the
soft version was deemed appropriate. On one hand, a crawling peg helps control inflation
when it is brought down from 30%-40%, but it is less useful when a lower level is envisaged,
since the crawl incorporates inflation expectations. On the other hand, exchange rate
flexibility was seen as an asset for an economy as big and rigid as Romania was at the time,
especially given the upcoming stages of capital flow liberalisation.
Against this background, Romania opted for inflation targeting as early as 2002, even though
it took several years of preparations until the actual adoption, in August 2005. The NBR
chose the "light" version of the strategy, which meant retaining the managed float feature of
the exchange rate regime. The actual form that inflation targeting took in Romania matched
the "managed-floating plus" concept, considered the most suitable choice for an
emergingmarket economy involved in the global capital market. This concept, introduced by Goldstein
in 2002, combines the managed float part, allowing for FX market interventions in order to
smooth out excessive volatility, with inflation targeting as a monetary policy strategy and an
active pursuit of measures to limit the degree of currency mismatches in the economy. As a
matter of fact, in an IMF paper published in 2003, the light version of inflation targeting is
found to be widely spread among emerging economies, where fiscal dominance continues to
weigh and monetary policy cannot set aside concerns over financial stability and external
equilibria.
2. Light inflation targeting in Romania
Drawing the line after more than a decade of inflation targeting, I would say that we have
managed to deliver steady disinflation and anchor expectations, even though the frequent
occurrence of exogenous shocks led to high volatility in inflation and the occasional missing
of annual targets. All central banks are familiar with supply-side shocks related to a surge or
fall in commodity prices, but in Romania we have also had to deal with large (and not
necessarily predictable) adjustments in administered prices and frequent changes in indirect
taxation. Some of the latter were inherent to EU membership (i.e. alignment of some excise
duties), but others were related to an erratic tax legislation. In such an environment, two
features of the inflation targeting framework as implemented in Romania appear as
particularly relevant:
• First, the focus on the medium-term achievement of the inflation objective, rather
than hitting the target all the time. This approach allows for sustainable price stability
without incurring the cost of excessive volatility in output and employment.
• Second, the ex-ante definition of a set of escape clauses that limit the central bank's
responsibility in attaining the annual target:
1. Marked increases/decreases in commodity prices
2. Natural disasters and other similar exceptional events that induce cost-push or
demand-pull inflationary effects
3. Large fluctuations of the exchange rate of the leu that are decoupled from
domestic economic fundamentals, as well as from the monetary policy
pursued by the National Bank of Romania
4. Major deviations from the administered price adjustment programme
announced by the Government, in terms of both magnitude and proposed
calendar
5. Divergence of the fiscal and income policies, in terms of implementation and
outcomes, from the programmed coordinates
3. Case in point: monetary policy under a string of VAT changes
To give you a flavour of the environment the monetary policy has had to operate in lately, we
had three VAT rate cuts from 2013 to 2016, after a hike in 2010, and another cut is
scheduled for 2017. Currently, the annual inflation rate stands at -3.25 percent, the most
negative value in the EU. Excluding the first-round effects of the VAT cuts in mid-2015 and
early 2016, headline inflation would have hovered around +1 percent. Consequently, the
negative inflation we are dealing with now is not at all a condition brought about by a
persistent lack of demand, as economic activity, employment and wages are actually
buoyant. This is just a transitory development, induced by the aforementioned indirect tax
cuts.
The textbook policy choice would be to accommodate the temporary deviation from the
inflation target and focus on the VAT-adjusted inflation developments - especially since the
latter paint a quite different picture.
If I may be allowed a short digression, the very recourse to a VAT-adjusted inflation measure
in our analysis and communication came under fire. This is by no means different in nature
than the Eurostat's HICP at constant taxes - just more refined, in the sense that we take into
account the fact that the pass-through of a VAT change is below 100% for most CPI items.
Coming back to the current economic context, it should be pointed out that behind the
"perfect storm" of deflationary exogenous shocks (low energy, food and metal prices,
successive VAT rate cuts), demand-side inflationary pressures are looming: a positive output
gap is emerging, unit labour cost pressures are building up, fiscal policy is taking a strongly
expansionary turn.
As such, while medium-term prospects appear to call for a tightening bias of monetary policy,
the short-term context of deeply negative inflation makes communication with the public
rather challenging. Specifically, we have to contend with the idea that the central bank should
lower interest rates in response to VAT rate cuts. It proves more difficult than we thought to
make people understand that the current negative readings in inflation are just transitory and
reflect neither postponed consumption, nor sluggish wage growth one would associate with
negative inflation expectations - these actually remained anchored to the target. Therefore,
none of the ingredients which make for a scary deflationary trap are present.
Frankly, I understand that the general public is not familiar with concepts like overheating or
positive output gap, but I believe that annual growth rates to the tune of 20% for retail sales
and in excess of 10% for wages are more than self-explanatory. Still, with all the obvious
signs - even for non-economists - that the economy is growing fast, we are criticised for not
fighting deflation.
The recent experience has made us painfully aware that - despite the large amount of
information provided through a wide range of communication vehicles - our messages get
through to a much lesser extent than we had thought. Therefore, we should enhance our
efforts in escaping the professional jargon and trying to be as accessible as possible when
explaining to the public the rationale behind our monetary policy decisions.
If I were to conclude on Romania's experience with inflation targeting, I would say that it
worked quite well, even though the concept of inflation targeting has not been immune to
criticism, especially in the post-crisis period. I would mention here Axel Weber, who
suggested in 2015 that inflation targeting is a simplistic framework that could not stabilise the
value of money in a complex and constantly evolving economic environment.
However, his opinion is not shared by other well-known economists. For instance, in 2013
Charles Wyplosz stressed that even though there are times when inflation targeting seems
inconvenient and possibly counter-productive, the alternatives - monetary targeting,
nominalGDP targeting or no explicit strategy at all - would probably not have done a better job.
Along the same lines, Lucrezia Reichlin and Richard Baldwin concluded that inflation
targeting should continue to be refined, not replaced. Of course, since I come from a central
bank practicing inflation targeting, I tend to agree with the latter line of thought, as I believe
that, whatever its faults, the strategy has enough intrinsic flexibility to enable it to address
them.