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Minutes of the monetary policy meeting of the National Bank of Romania Board on 7 February 2018

The National Bank of Romania Board members present at the meeting: Mugur Is?rescu, Chairman of the Board and Governor of the National Bank of Romania; Florin Georgescu, Vice Chairman of the Board and First Deputy Governor of the National Bank of Romania; Eugen Nicol?escu, Board member and Deputy Governor of the National Bank of Romania; Liviu Voinea, Board member and Deputy Governor of the National Bank of Romania; Marin Dinu, Board member; Daniel D?ianu, Board member; Gheorghe Gherghina, Board member; Ágnes Nagy, Board member; and Virgiliu-Jorj Stoenescu, Board member.

During the meeting, the Board discussed and adopted the monetary policy decision, based on the data and analyses on the recent characteristics and the updated forecast of medium-term macroeconomic developments submitted by the specialised departments, as well as on other available domestic and external information.

In their addresses, Board members first referred to recent inflation developments. It was shown that the annual inflation rate had continued to rise at end-2017, going up from 3.23 percent in November to 3.32 percent in December, i.e. inside the variation band of the flat target, but very close to its upper bound and significantly above the forecast. They observed that, during 2017 Q4, the annual inflation rate had almost doubled, its advance being much steeper than anticipated. Behind that evolution had stood all major CPI components, especially administered prices – in the context of the increase in the electricity price –, core inflation, as well as the fuel price, as a result of higher international oil prices and the hike in the excise duty on motor fuels; lower contributions had made the VFE prices and the tobacco product prices.

Board members emphasised the important contribution of the adjusted CORE2 inflation, whose annual dynamics had accelerated to 2.5 percent in December 2017, markedly above the forecast, from 1.8 percent in September. It was deemed that the evolution was in line with the new larger-than-expected widening of the positive output gap in Q3 and with the likely protraction of its upward trend in Q4, as well as with the sustained dynamics of unit labour costs. Moreover, given that the upward movement had been more significant on the food segment, followed by the services segment, Board members also noted the influences arising from the dynamics of some international agri-food commodity prices and from the relative weakening of the leu versus the euro, as well as from the likely indirect effects of the increases in the oil price and the prices of some utilities, inter alia in the context in which short-term inflation expectations had been more firmly adjusted upwards in the course of Q4. The renewed acceleration posted in November by the annual dynamics of industrial producer prices on the domestic market for consumer goods, and particularly for non-durables, was also deemed indicative of stronger inflationary pressures from fundamentals, as well as from some supply-side shocks.

As for the cyclical position of the economy, Board members showed that the new statistical data reconfirmed the significantly faster-than-expected acceleration to 8.8 percent in the economic growth in Q3, as well as the overall composition of its determinants, on both the demand and supply side, implying a notably wider-than-anticipated opening of the positive output gap, moderated, however, by a temporary advance in potential GDP, under the impact of the positive supply-side shock generated by the bumper agricultural year. Reference was also made to the key role of private consumption – spurred by new income-boosting measures as of 1 July 2017, overlapping with the favourable financial conditions and the labour market context –, as well as to the positive contributions made by gross fixed capital formation and general government consumption. At the same time, Board members also underlined the growing negative contribution of net exports, arising from the widening unfavourable differential between the growth rate of exports and that of imports, causing the negative balance on trade in goods and services to almost treble versus the same year-earlier period.

Moreover, the economic expansion was seen as very likely to re-enter a decelerating trend in 2017 Q4 - 2018 Q1, with its annual dynamics remaining, however, markedly faster than in the November forecast, implying a relative increase in the positive output gap and its inflationary pressures. In addition, according to the latest data, the role of private consumption as the engine of economic growth had consolidated in 2017 Q4, while the contractionary impact of net exports seemed to have strengthened. In that context, Board members showed their concern regarding the further uptrend in the unfavourable differential between the annual growth rate of exports and that of imports of goods and services in October-November 2017, with a decisive contribution to the faster annual pace of widening of the current account deficit. The potential sources of the shortfall on the international trade in goods were discussed and it was shown that, at the time, more than a quarter of it came from the food segment, given that the domestic agri-food sector was facing, inter alia, structural competitiveness issues affecting the production chain, especially the upstream stages.

Board members expressed their concerns about the labour market tightness as well. They remarked that the new highs in the number of employees in the economy seen in the first months of 2017 Q4 had continued to be associated with a further slowdown in its annual dynamics caused, inter alia, by increased difficulties in recruiting personnel, as also indicated by the record high skill mismatch index in Q3. Reference was also made to the downtrend in the ILO unemployment rate resumed in November – to a new historical low of 4.6 percent in December –, as well as to the relatively robust employment intentions for 2018 Q1 as indicated by surveys, suggesting a new tightening of the labour market after the short halt in that trend in the latter part of 2017. In that context, emphasis was placed on the high level, from a historical perspective, further reported by the annual dynamics of the average gross nominal wage in October-November 2017, as well as on the rise seen in November by the annual change in unit wage costs in industry, including in some consumer goods industries. At the same time, however, Board members observed that, in real terms, the annual growth rate of average net wage had slowed down slightly, mainly following the step-up in inflation, and that the near-term outlook for wage earnings was surrounded by high uncertainties, especially in the private sector, inter alia in the context of transferring the contributions payable by the employer to the employee.

Relative to monetary conditions, Board members noted the evolution of the key interbank money market rate close to the monetary policy rate after the latter’s increase to 2 percent – the highest level in the region and the EU. Reference was also made to the recent behaviour of interest rates on new loans and new time deposits – heterogeneous across institutional segments and categories of bank products – and implicitly to the characteristics of the pass-through of the monetary policy rate. Furthermore, Board members observed that, in spite of a slight slowdown, the annual growth rate of credit to the private sector had remained robust in the last month of 2017, solely on account of the lei component, whose share had gone up to 62.8 percent in total.

During the discussions on the new medium-term forecast, Board members showed that the updated path of the projected annual inflation rate ran well above the upper bound of the variation band of the target in the first quarters of 2018, hence exceeding the previously-anticipated values, before reverting inside the band in 2019, albeit staying in its upper half, at a relatively similar level to that forecasted in the November 2017 Inflation Report. Specifically, after rising probably towards 5 percent at mid-2018, the annual inflation rate was expected to fall to 3.5 percent in December 2018 and to decline very slowly over the following four quarters to 3.1 percent, the same level as previously forecasted.

In that context, some Board members underlined the temporary nature of the significant overshooting of the upper bound of the variation band of the target expected for this year, given that the likely sizeable fluctuation in the annual inflation rate was exclusively attributable to the action of supply-side factors, more strongly inflationary in the short run than previously projected, but at the same time generating relatively sturdier disinflationary base effects starting 2018 Q4. The most notable influences were expected from the recent hikes in electricity, natural gas and heating prices, as well as from costlier fuels, amid higher oil prices and the increase in the excise duty on motor fuels. Similar effects would stem from the faster dynamics of VFE prices, as well as from the hikes in tobacco product prices in the closing months of 2017, all of which overlapped in the early months of 2018 with the inflationary base effects associated with the previous cuts and removals of indirect taxes and declines in administered prices.

At the same time, however, Board members voiced concern over the risk that the strong inflation bout driven by supply-side shocks might trigger significant side effects via the worsening of medium-term inflation expectations and implicitly compound the efforts and costs of bringing inflation back under control, especially amid growing pressures from fundamentals. Hence the need for an adequate monetary policy response. The relationship between domestic prices and exchange rate dynamics and the uncertainties associated with the future evolution of fuel prices and some utility prices, owing inter alia to high volatility of oil prices, were also considered relevant in terms of the risk induced by the inflation bout.

It was also remarked that the strengthening of inflationary pressures from fundamentals was expected to be relatively more pronounced than anticipated earlier, given that the annual adjusted CORE2 inflation rate was envisaged to pick up relatively faster on the short time horizon and stay around 3.7 percent in 2019, thus being the sole culprit for the forecasted annual headline inflation rate staying in the upper half of the variation band of the target during next year. It was deemed that such pressures would primarily stem from the cyclical position of the economy and from the steep uptrend in inflation expectations over the short term, as well as from import prices in 2019. By contrast, wage costs were anticipated to exert less intense pressures than previously forecasted across the entire projection horizon. For the latter part of 2019, a relative alleviation of pressures was also expected from the positive output gap likely re-entering a downward path at the beginning of next year.

During the discussions on the likely pattern of excess aggregate demand, Board members noted that the much stronger-than-expected acceleration in economic growth during 2017 was anticipated to be followed by relatively more pronounced slowdowns in 2018 and 2019. However, the forecasted dynamics of economic activity would remain robust in 2018, further taking higher values than the potential GDP growth rate, but would drop in 2019 to lower values, also due to the upward revision of the latter; developments pointed to relatively more sizeable excess aggregate demand until towards end-2018 and subsequently to a gradual contraction thereof, also in relation to the previous forecast. It was shown that the outlook stemmed mainly from the likely protraction of the expansionary nature of fiscal and income policies in 2018, followed by their return to a countercyclical stance in 2019, as well as from the anticipated deceleration in the growth rate of households’ real disposable income, inter alia as a result of the step-up in inflation; the outlook also implied gradually less accommodative monetary conditions, envisaged to become quasi-neutral in 2019, and improved EU funds absorption, as well as faster economic growth in the euro area/EU and globally.

According to Board members’ assessment, household consumption would likely remain the key driver of economic growth during 2018-2019 as well, whereas the contribution made by investment was expected to be modest, despite the slight recovery anticipated for 2018, and net exports were seen having a sizeable negative contribution, associated with a possible increase in the current account deficit as a share of GDP. Concerns were reiterated about the composition of economic growth and the need for a solid rebound in investment, conditioned, however, not only on the carrying out of public investment and the absorption of EU funds, but also on investor confidence, depending in its turn on the evolution of fundamentals and on the quality of the business environment, as well as of the governance and legislative frameworks.

Following the analysis, Board members considered that the current context called for an increase in the monetary policy rate by another 0.25 percentage points. Such a response was warranted, inter alia|, by the persistence of upside risks stemming from the fiscal and income policy stance in 2018 or from a budget expenditure composition further geared towards supporting consumption to the detriment of public investment, which would likely impair the Romanian economy’s growth potential and lead to relatively higher values of the positive output gap, and hence of the inflation rate, over the medium term, as well as to a wider current account deficit.

Mention was also made of the upside risks induced by a possibly higher increase in corporate costs, along with tighter profit margins, due mostly to the new fiscal and income-related measures, as well as to labour market tightening. Board members also referred to the recent heightening of volatility on the international financial market, as well as to the potentially faster-than-expected growth of the euro area and global economies, amid the synchronised above-trend expansion of developed and emerging economies, fostered inter alia by the persistence of loose financial conditions worldwide.

Board members deemed those risks as prevailing in the current context. They also pointed out, however, the uncertainties surrounding the shift in social security contributions onto employees, as well as those stemming from the possibility of corrective fiscal measures during 2018, with a view to ensuring compliance of the fiscal deficit with the 3 percent-of-GDP reference value. Reference was also made to the declining trend in household and corporate confidence, as well as to other possible adverse effects exerted on the business environment by the recently-implemented package of fiscal and wage measures, but also by the uncertainties circumscribed to that package, mention being also made of the slow-in-coming recovery of EU funds absorption.

Turning to the external environment, discussions touched upon the persistence of low inflation in the euro area and in other EU countries, the robust economic expansion notwithstanding, as well as upon the monetary policy stances of the major central banks, and especially of the central banks in the region. Against that background, Board members reiterated the importance of a balanced macroeconomic policy mix, deemed essential also from the standpoint of avoiding the overburdening of monetary policy and preventing undesired effects across the economy; some members mentioned among such effects a potential re-euroisation process that might seriously affect monetary transmission as well.

Under the circumstances, the NBR Board unanimously decided to increase the monetary policy rate to 2.25 percent from 2.00 percent, as well as to raise the deposit facility rate to 1.25 percent from 1.00 percent and the lending (Lombard) facility rate to 3.25 percent from 3.00 percent. In addition, the NBR Board unanimously decided to maintain the existing levels of minimum reserve requirement ratios on both leu- and foreign currency-denominated liabilities of credit institutions.

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