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NATIONAL BANK OF ROMANIA - INFLATION REPORT – August 2014 –
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SUMMARY –
Developments in inflation and its determinants
In 2014 Q2, the annual CPI inflation rate remained below the lower bound of the ±1 percentage point
variation band of the 2.5 percent flat target. The June reading, i.e. 0.66 percent, stood 0.9 percentage
points below the end-2013 figure and 0.7 percentage points below that forecasted in the May 2014
Inflation Report.
While fundamental factors further contributed, as forecasted, to consolidating inflation rate dynamics
in line with the price stability definition adopted by the NBR, the temporarily very low inflation levels
are the result of the recent overlapping of favourable supply-side shocks, part of which were manifest
at the same time across the region. The effects of the bumper crop in 2013 and the cut in the VAT rate
for some bakery products from 24 percent to 9 percent as of 1 September 2013 were already
incorporated into the previous projection, leading to the temporary reduction in the annual CPI
dynamics. The decrease in the inflation rate below the levels projected in the May 2014 Inflation
Report is accounted for by the impact of some developments that occurred or were confirmed after its
publication: the appreciation of the leu in Q2, the good supply of vegetables, favoured by the weather
conditions in the first half of the year, as well as the persistence of subdued inflation in the euro area,
which fed partly through into the dynamics of aggregate domestic prices via developments in import
prices.
In June 2014, the adjusted CORE2 index1 saw a -0.6 percent annual dynamics, down 0.5 percentage
points from end-Q1. This rate of change was mainly triggered by the appreciation of the leu, which
passed through especially into market services prices. The negative values posted by the core inflation
rate in the recent months have a temporary nature, this inflation measure being anticipated to return to
positive territory once the statistical base effect of the above-mentioned VAT rate cut has faded.
Looking beyond the incidental influences, the evolution of the adjusted CORE2 index continued to be
supported by fundamental factors, namely the persistence of the negative output gap and the downward adjustment of inflation expectations.
Except for the increase in fuel prices, that gained pace after the excise duty hike by 7 eurocents per
litre as of 1 April, in Q2, the developments in headline inflation components, influenced particularly
by supply-side factors, contributed to more pronounced disinflation. The main drivers behind this
evolution were: the favourable supply of vegetables, which led to a more rapid decline in volatile food
prices (VFE2); the fall in the electricity and natural gas billing prices; the partial pass-through into
tobacco prices until quarter-end of the hike in the related excise duty starting with 1 April.
The downward trend in unit labour costs across industry, visible starting with 2013 Q2, came to a halt
in April-May 2014, on account of a marked deceleration in the growth rate of labour productivity.
However, this evolution appears to be incidental, being attributable to the Easter calendar effect and,
consequently, it is expected to see a subsequent correction. Across the economy as a whole, gross
nominal wage earnings continued to rise at a moderate pace. Although this growth pace is expected to
accelerate in July as a result of the new hike in the gross minimum wage across the economy, in the
period ahead the risk of significant inflationary pressures stemming from wage-related costs appears to
be relatively low. Economy-wide, maintaining an adequate match between wage increases and labour
productivity gains over the medium and long term remains however of the essence for consolidating
price stability.
Monetary policy since the release of the previous Inflation Report
In its meeting of 6 May 2014, the NBR Board decided to keep the monetary policy rate at 3.50 percent
per annum. The decision was substantiated by the analysis of the macroeconomic prospects stemming
from the updated NBR forecast as well as from the related risks, along with the analysis of the
pass-through in the economy of the impact exerted by the previous adjustments in the monetary policy conduct. The forecast reconfirmed the prospects for the annual inflation rate to return inside the
variation band of the target and remain there in the medium run, after the fading in 2014 H2 of the
effects generated by the favourable supply-side shocks in 2013.
The risks associated with the forecast were primarily posed by the external environment and referred to: the variability of investors’ risk appetite for emerging economies overall, against the background of high uncertainty correlated with the unfavourable geopolitical and regional developments, the ongoing cross-border deleveraging in the banking system and the potential effects of monetary policy stance adjustments by major central banks worldwide. In addition, the persistent structural rigidities of the Romanian economy contribute to the relevance of the spillover risks of unfavourable external shocks.
Subsequent to the decision taken in May, the annual inflation rate remained on a trajectory below that
previously forecasted. Some one-off influences (the evolution of volatile prices, especially food prices,
the nominal appreciation of the national currency) during this period, aside from the fundamental
factors, implied uncertainty concerning the consolidation of this path in the medium term. At the same
time, loans in lei, saving and investors’ and rating agencies’ perception of the Romanian economy had
entered favourable paths and the international reserves were further at adequate levels, even after the
repayment of most of the loan taken by Romania from the International Monetary Fund in 2009-2010.
In its meeting of 1 July 2014, the NBR Board considered that these developments, along with the need
to consolidate saving, and the inflation prospects allowed a certain adjustment of the monetary policy
stance, including through the medium-term gradual alignment programme of the minimum required
reserves to the European levels. In this context, the NBR Board decided to keep the monetary policy
rate at 3.50 percent per annum, cut the minimum reserve requirement ratio on foreign currency-denominated liabilities of credit institutions to 16 percent from 18 percent, while keeping unchanged at 12 percent the ratio on leu-denominated liabilities.
Inflation outlook
The current projection sees the annual CPI inflation rate returning inside the ±1 percentage point
variation band of the target in 2014 Q3 and remaining there until the projection horizon.
The macroeconomic forecast envisages economic activity to consolidate over the reference period,
amid the gradual rebound in domestic demand as the major driver of growth starting 2014. Similarly
to the previous projection, the anticipated contributors to this evolution are: the rise in households’ real
disposable income, also due to the projected inflation rate staying at levels consistent with the inflation
target, consolidation of production-oriented capital inflows (structural and cohesion EU funds and
foreign direct investment flows), as well as the phased adjustment of lending conditions, also as a
result of the projected configuration of real broad monetary conditions.
The rebound in domestic demand will chiefly be led by the consolidation of household consumption
growth in 2014, whereas investment is expected to recover no sooner than the latter half of this year.
Hence, gross fixed capital formation is foreseen to make a positive contribution to growth starting
2015. The advance in domestic demand will also induce a relatively faster rise in imports, entailing
a slightly negative contribution of net exports to growth over the projection interval, despite the further
favourable performance of exports. Therefore, the share of the current account deficit in GDP is
expected to stabilise below 2 percent from 2014 onwards, significantly lower than the pre-2013 levels.
These assumptions of the baseline scenario entail the lack of any significant corrective pressure on the
leu exchange rate arising from the external position until the projection horizon. The negative output gap has been revised for the entire forecast interval to levels implying relatively stronger disinflationary pressures than in the previous projection. The reassessment took account of:
GDP growth in 2014 Q1, which stood below the prior projection; the mainly downward marginal
revision of the seasonally-adjusted historical series of real GDP by the NIS; a slightly more restrictive
projected impact from external demand; the stronger leu in 2014 Q2, thereby moderating the
stimulative nature of broad monetary conditions, especially in the first part of the projection interval.
The deviation of GDP from its potential level is foreseen declining gradually, but remaining at negative values throughout the projection interval.
The baseline scenario of the current projection places the annual CPI inflation rate at 2.2 percent at
end-2014 and 3.0 percent at end-2015, 1.1 percentage points and 0.3 percentage points, respectively,
lower than those forecasted in the May 2014 Inflation Report.
CPI inflation and the adjusted CORE2 inflation are anticipated to stay significantly below the levels in
the previous forecast throughout the projection interval. The magnitude of the revision, relatively high
in the first part of the envisaged period, is attributed to the reassessment of more favourable influences
from factors exerting effects especially in the near run, as well as – to a lesser extent – from factors
exerting persistent effects, considering also the developments recorded or confirmed after the
publication of the May projection.
The annual adjusted CORE2 inflation rate is foreseen to rise to 0.8 percent at the end of 2014 Q3,
from the negative value recorded at end-2014 Q2. The trend reversal in its dynamics is mostly due to
the fading away of the transitory statistical effects of the cut in the VAT rate for some bakery products
as of 1 September 2013. Further on, core inflation rate is projected to follow a moderate uptrend (to as
high as 2.1 percent at the projection horizon), as a net effect of forecasted developments in
fundamentals: the negative output gap narrowing gradually, inflation expectations stabilising inside
the variation band of the central target and import price dynamics3 slowing down in the first part of the projection interval and stabilising thereafter. The downward deviations from the previous projection
stem from currently forecasting a relatively wider negative output gap throughout the forecast interval,
as well as from lower inflation expectations and imported inflation over most of the reference period.
The exogenous CPI components in terms of the monetary policy scope are forecast to post diverging
trends in their annual dynamics. While tobacco product and fuel prices are projected to rise faster in
the first half of the projection interval, volatile food prices and administered prices are seen increasing
at a quicker pace in the latter half of the period than forecasted for 20144. Compared to the previous
projection however, the cumulative contribution of these components to the headline index dynamics
was revised markedly downwards throughout the projection interval. This revision owes mainly, in
terms of direction and magnitude, to that of administered price dynamics. The latter was chiefly the
result of new assumptions regarding the effects of the gradual electricity market deregulation on
electricity prices given the recent developments. The new scenarios on the other exogenous components had marginal contributions to the CPI dynamics revision, except the favourable revision
of fuel price inflation in the first part of the projection interval and of tobacco product price inflation in
the final two quarters of the reference period.
The CPI inflation rate is expected to return inside the variation band of the central target in 2014 Q3
under the impact of the projected dynamics of its components. Having touched a historical low at the
end of 2014 Q2, CPI inflation will incorporate the trend reversal in core inflation and the abating
impact of last year’s bumper crop on volatile food prices. Except an incidental, and implicitly
transitory, reduction in 2015 Q1, the annual CPI inflation rate is anticipated to stick to a moderately
upward path and subsequently stabilise around 3.0 percent close to the projection horizon. At the same
time, the average annual inflation rate will continue declining in 2014 Q3, falling below the lower
bound of the ±1 percentage point variation band of the target, before reversing its trend and re-entering
the variation band starting with 2015 Q1.
The projected monetary policy stance will further seek to ensure an adequate set-up of real broad
monetary conditions for maintaining the inflation rate inside the variation band of the target over the
medium term, amid the effective anchoring of inflation expectations. This will also help pave the way
for a gradual, prudentially-compliant recovery of lending to the private sector, leu-denominated lending in particular, and for a lasting consolidation of economic growth.
The assessment of risks to the current inflation forecast points further to a balance tilted to the upside,
albeit to a lower extent than anticipated in the previous round. Similarly to the assessment in the previous Inflation Report, external risks are seen as somewhat balanced, amid still elevated uncertainty. They relate to the variability of investors’ risk aversion towards the emerging economies, which may occur given the potential escalation of recent regional and geopolitical tensions and the ongoing process of cross-border deleveraging and restructuring of some euro area banking groups. Adding to these are the uncertainties surrounding the impact of possible monetary policy stance adjustments by major central banks worldwide. The materialisation of these risks would entail changes in investor exposure to the emerging economies as a whole, as well as reallocations among them. In such a context, in Romania, higher volatility of capital flows might lead to fluctuations – which would not be triggered by changes in fundamentals – in the leu exchange rat and to ensuing deviations of the macroeconomic projection from the baseline scenario in terms of the path in inflation and economic growth.
Nevertheless, given the investors’ medium- and long-term preference for the economies with
relatively low external and domestic macroeconomic imbalances, as well as for those implementing
structural reform programmes, the recent improvement in Romania’s economic fundamentals, the
consolidation of the visibility of Romanian assets in relevant indices to global investors, along with
the fact that investors’ exposure is still lower than that to other emerging economies and serves the
purpose of portfolio diversification carry the potential to mitigate to some extent the risk associated
with unfavourable effects of global or regional portfolio shifts.
On the other hand, external risk mitigation is expected to be contained by the persistence of structural
rigidities across the Romanian economy that stymie the adjustments necessary to moderate the effects
of adverse shocks. From this perspective, the uncertainty about the firm and consistent implementation
of the set of structural reforms and other measures agreed with international institutions (the EU, the
IMF and the World Bank) remains a cause of concern, particularly in the context of elections later this
year. Any delay and/or failure to fully comply with the assumed commitments might cause the effects
of possible unfavourable domestic or external shocks to feed through to the inflation rate and economic growth.
The specific uncertainties surrounding the aggregate consumer price index components that may be hit
mainly by supply-side shocks continue to pose relevant risks during the reference period.
The uncertainty about administered prices is associated, on the one hand, with the magnitude of the
impact of deregulation stages relating to the electricity market in particular and to the natural gas
market, since this calls also for projections of developments in market prices and, on the other hand, with the spillover effects of a potential escalation of conflicts in the Ukraine and/or the Middle East.
The above-mentioned geopolitical tensions, coupled with possibly unfavourable movements in the
EUR/USD exchange rate, give rise to risks of higher global commodity price increases than those
included in the baseline scenario.
The balance of risks to the domestic food price developments is assessed as slightly tilted to the upside
against the baseline scenario coordinates, given that some of the favourable risk factors mentioned in
the May 2014 Inflation Report have already materialised, amid the plentiful vegetables supply in
2014 H1, and considering the weather-dependent nature of agricultural output, as well as the assumption of a normal agricultural year for 2015.
Monetary policy decision
Considering the outlook for the annual inflation rate to run at markedly lower readings than previously
forecasted, i.e. below the midpoint of the flat target until mid-2015 and in the upper half of the
variation band in the latter part of the medium-term projection horizon, given the anticipated
overlapping of the impact of one-off factors with the persistent effects of the negative output gap and
the downward adjustment in inflation expectations, the Board of the National Bank of Romania
decided in its meeting of 4 August 2014 to lower the monetary policy rate by 0.25 percentage points to
3.25 percent per annum. The NBR Board also decided to continue to pursue adequate liquidity
management in the banking system and to maintain the existing levels of minimum reserve
requirement ratios on both leu- and foreign currency-denominated liabilities of credit institutions.