Sofia, 34 October 2005

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Seminar organised by the Bulgarian National Bank
EMU and the New Member States - a Year After
Accession
Towards a New Strategy of Monetary
Policy Inflation Targeting in Romania
Florin Georgescu, PhD First Deputy
Governor National Bank of Romania
Sofia, 3-4 October 2005
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SUMMARY

• A) Inflation Targeting in Romania
• I. Rationale Behind the Adoption of
  Inflation Targeting
• II. Key Features
• III. International Experience
• IV. Prerequisites
• V. Advantages
• VI. Features of NBRs Inflation Targeting
  Strategy
• VII. Exchange Rate Policy
• VIII. Quarterly Forecasting
  Decision-Making Process
• IX. Forecast Horizons
• X. Forecasting Cycle
• XI. The Core Model
• XII. The New Inflation Report
• XIII. Communication

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• B) Charts
• 1. Inflation Rate (annual data)
• 2. Inflation Rate (monthly data)
• 3. Inflation Forecast
• 4. NBR Policy Rate
• 5. Financial Intermediation
• 6. General Government Deficit/GDP
• 7. Reserves and Debt Indicators
• 8. Total External Debt
• 9. MLT External Debt
• 10. Public Debt Stock
• 11. Inflation Rate and Interest Rates
• 12a. Non-Government Credit
• 12b. Total Credit and Non-Government Credit

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I. Rationale Behind the Adoption of Inflation
Targeting

• Necessary commitment to disinflation due to
  forthcoming European accession
• Weakening relationship between money aggregates
  and inflation
• Needed focus on inflation rather than on
  intermediary targets
• With capital account liberalization, exchange
  rate pegging is not a viable alternative
  inflation still high, Balassa-Samuelson effect
  would slow down disinflation

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II. Key Features

• Primary objective of monetary policy to ensure
  and maintain the aggregate price
  stability
• Use of the whole range of monetary policy tools
  for reaching the inflation target
• Proactive monetary policy stance (forward-looking
  behaviour)

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Key Features (2)

• Transparency of the monetary policy strategy
  by communicating to the
  general public the objectives, the decisions
  adopted, the rationale behind monetary policy
  decisions and the associated risks and
  uncertainties
• Increased efficiency of monetary policy on
  medium-term

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III. International Experience

• Central banks of 21 countries adopted inflation
  targeting strategy
• Initially, inflation targeting strategy was
  adopted only by some developed
  countries
• Subsequently, the strategy proved to be an
  attractive alternative to emerging countries
• Large economic imbalances had been solved prior
  to the adoption of inflation
  targeting strategy

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IV. Prerequisites

• The annual inflation rate is in the single-digit
  range
• The NBR has full operational independence
  (by its legal Statute)
• The financial sector is stable and sound,
  although financial intermediation is needed to
  increase
• Fiscal dominance is no longer a threat

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Prerequisites (2)

• Inflation targets for the coming years have been
  agreed on together with the government
• The central bank has improved its
  inflation-forecasting capacity
• Disinflation progress over the past few years has
  led to the strengthening of NBR
  credibility

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V. Advantages

• Reducing time inconsistency by increasing the
  responsibility of the central bank for achieving
  its primary objective, i.e. price stability
• Flexible and transparent regime that is
  operational even under an unstable relation
  between monetary aggregates and inflation
• Disinflation with relative minimisation of costs,
  a more direct impact on inflation expectations

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VI. Features of NBRs Inflation Targeting
Strategy

• CPI-based inflation target
• Target set as a midpoint within a target band
  of 1 percentage point
• Annual targets set for a longer time horizon
  (initially 2 years)

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Features of NBRs Inflation Targeting Strategy
(2)

• Flexible interpretation of inflation targeting
  (mainly its co-existence
  with the managed floating regime)
• Ex ante definition of a narrow set of
  circumstances which are independent from the
  monetary policy influence and restrict the NBRs
  responsibility for reaching the inflation target
  (escape clauses)
• Joint announcement of inflation targets by the
  NBR and the government

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VII. Exchange Rate Policy

• Further managed floating regime, with market
  playing an increasing role in determining the
  exchange rate
• Less frequent interventions by the NBR
• Exchange rate unpredictability in the short run,
  in order to discourage speculative capital
  inflows following capital account liberalization

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VIII. Quarterly Forecasting Decision-Making
Process

• Task Force interdepartmental working group
• Prepares near- and medium-term forecasts on
  economic growth and
  inflation rate
• Monitors the main economic and monetary
  indicators on a monthly basis
• Draws up the Inflation Report
• Monetary Policy Committee
• Examines the initial conditions for the core
  model
• Assesses the forecasts and recommendations on the
  monetary policy measures
• Analyses the Inflation Report and makes
  recommendations
• NBR Board
• Makes the monetary policy decision taking account
  of the formulated risks and uncertainties
• Analyses and adopts the Inflation Report

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Quarterly Forecasting Decision-Making Process
(2)
Flow of information in the forecasting process
at the National Bank of Romania
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IX. Forecast Horizons 

• Near-term forecast (2 quarters)
• ARMAX model for the main CPI components
  (food, non-food, services)
• Expert judgement forecast for CPI components
• Useful for determining the starting point of
  medium-term forecast and for monitoring in
  between two forecasting cycles

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Forecast Horizons (2)

• Medium-term forecast (8 quarters)
• Based on a quarterly projection model (QPM) that
  provides a
  description of dynamics of the main macroeconomic
  variables and their interaction
• QPM is used for generating macroeconomic
  development scenarios, assessing the risks of
  potential shocks and analysing alternative
  monetary policy measures
• QPM is based on economic theory, assuming
  modelling of economic agents expectations and
  the convergence of the economy towards long-term
  equilibrium
• QPM is a flexible model allowing the use of
  additional information and expert opinions
   provided by specialists of the NBR and of other
  institutions

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X. Forecasting Cycle

• Quarterly cycle relying on frequency of data on
  GDP
• Forecasting process, formulation of monetary
  policy decisions and drafting of Inflation Report
  last for about one month
• Forecasting cycle does not require quarterly
  frequency of monetary policy decisions
• monetary decisions may also be taken between two
  forecast meetings based on the developments
  identified during monitoring

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XI. The Core Model

• Assessing the current position of the economy
• Initial conditions for the core model GDP trend,
  neutral real interest rate, equilibrium real
  exchange rate, their medium-term profiles and
  current gaps
• Providing a consistent view on recent economic
  developments, current inflationary pressures, and
  real monetary conditions stance
• Role
• Integrates information from history, near-term
  forecasting and
  expert judgement
• Generates endogenous interest rate path which can
  serve as policy guideline
• Used to generate risk scenarios and policy
  analysis

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The Core Model (2)

• Characteristics
• Small semi-structural calibrated model
• New-Keynesian core (short-term and medium-term
  non-neutrality)
• Well behaved steady-state
• Consistent with achieving multi-period inflation
  targets

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The Core Model (3)

• Structure
• Core inflation determined by own persistence,
  agents expectations, output gap, and import
  price inflation
• Output gap determined by own persistence and real
  monetary conditions
• Exchange rate determined according to uncovered
  interest parity including risk premium
• Forward-looking policy interest rate rule reacts
  to deviations of inflation from
  target, the output gap and smoothes out interest
  rate volatility
• Agents expectations modelled as hybrids of
  backward-looking (inertial) and forward-looking
  (model-consistent) expectations

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The Core Model (4)

• Features of the transmission mechanism
• Expectations channel quite significant for
  monetary policy direct influence on inflation
• Exchange rate channel also important
• direct channel, via pass-through strongest
• indirect channel, through influences on real
  sector relatively weaker
  at present
• Interest rate channel
• relatively weak in the past, steadily
  strengthening
• monetary policy impulses intermediated by
  relatively sluggish bank deposit and lending rates

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XII. The New Inflation Report

• Main communication tool with the public in order
  to anchor inflation expectations
• Since August 2005 quarterly Inflation Report
• Sections
• assessment of current economic developments
• rationale behind the monetary policy decisions in
  the reviewed period
• NBR projection on inflation rate developments on
  eight-quarter time horizon
• uncertainties and risks associated with the
  projection
• implications of the context on the monetary
  policy future stance

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XIII. Communication

• More transparent policy
• Formal announcement of adoption of full-fledged
  inflation targeting regime, with details on
  bandwidth, formalized exceptions etc.
• Formal announcement of calendar for
  policy-related Board meetings
• External communication based on publishing the
  new quarterly Inflation Report
  and on regular press conferences occasioned by
  its release
• Press releases on contents of between-forecast
  meetings and on the monetary policy
  decisions

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• CHARTS

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