The operational framework of monetary policy consists of the whole set of tools and procedures by which the central bank implements monetary policy in order to achieve its fundamental objective, which in the case of the National Bank of Romania (NBR) is ensuring and maintaining price stability.
By Leonardo Badea, Deputy Governor of the National Bank of Romania
For the Romanian public, the best-known instrument used by NBR is the monetary policy interest rate, which is in many ways the instrument with the most significant impact on consumer behavior, so implicitly on the short-term evolution of demand and eventually on the dynamic equilibria that lead to changes in prices in almost the entire economy. The nuance introduced here is important for the overall picture of the price formation mechanism in the Romanian economy, because, as we have seen in recent quarters, there are two important price segments represented by administered prices and prices closely related to goods traded on international markets. In their case, the functioning of the usual mechanisms of supply and demand is disrupted at local level, which is why the efficiency with which monetary policy instruments can act on them is diminished, a situation that is also valid with regard to the monetary policy interest rate. This is also the reason why these prices are included in the literature and in the practice of all central banks in the category of exogenous factors.
The above clarification is extremely important in the case of Romania, given that the primary source of the current increase in prices, manifested during the first three quarters of this year, was the notable rise in energy prices (according to data published in the most recent Inflation Report). For example, the contribution of the energy component (fuels, natural gas, electricity) to the increase in the annual inflation rate during the third quarter of 2021 amounted to 1.5 percentage points, half of the increase being explained by the increase in the price of natural gas. Another relevant example is that in the case of the annual CPI inflation rate of 6.29 percentage points at the end of September, 3.25 percentage points represented the contribution of the energy component. Of course, other influences are added, such as the increase in production costs with other raw materials, the attempt of economic agents to recover the losses accumulated since the beginning of the pandemic crisis or the favorable evolution of demand, but overall they accounted for less than half of the CPI advance.
Peculiarities of this kind have always existed, which is why central banks have developed over time and have been using a wide range of instruments designed to help achieve monetary policy objectives in addition to the key interest rate. It is also important not to lose sight of the fact that the whole toolkit of monetary policy must act synchronously within the broad framework of the macroeconomic policy mix, alongside fiscal policy, macro-prudential policy, and the set of structural policies designed to act on the supply side as well. This is particularly important given that, as we know, monetary policy acts mainly on short-term demand and has no influence on supply dynamics. Because most prices (except for the situations mentioned at the beginning of the article) are the result of correlating demand with supply, acting also on supply through other economic policies is likely to help reduce price volatility in the medium and long term and increase monetary policy efficiency in combating their short-term turmoil, but most importantly, in avoiding entering an inflationary loop. In the latter respect, in Romania, the absence of pressure from the labor market, which could otherwise have been a major link in the chain of price increases over time, is a positive situation.
Returning to the diversified toolkit of monetary policy, in Romania it also includes the permanent facilities offered by the NBR to eligible participants, according to Regulation no. 1/2000, respectively the lending facility and the deposit facility.
The lending facility allows banks to obtain a one-day loan from the central bank, against guarantees (eligible financial instruments set up as collateral), at a predetermined interest rate. This interest rate is normally a higher interest rate ceiling for overnight transactions between credit institutions in the money market. Banks that need liquidity during the day can borrow from other money market participants, but can also use this permanent facility if they have sufficient collateral. Due to the existence of this option, the cost of borrowing is limited by market mechanisms to rise above the interest rate on the lending facility.
The deposit facility allows credit institutions to place one-day deposits with the central bank at a predetermined interest rate. Due to market mechanisms similar to those described above, the deposit facility interest rate is normally the lower limit of the money market “overnight” interest rate. Actually, a credit institution will not be interested in making a deposit with another money market participant that is remunerated at a lower interest rate, as long as the central bank offers a higher level of remuneration within the permanent deposit facility.
Adding the elements described above, we see that the interest rates for these two permanent facilities offered by the central bank describe a corridor around the monetary policy interest rate. Through the two interest rates or as a whole through the corridor, the central bank aims mainly to limit the volatility of short-term interest rates for transactions between eligible money market participants (Bindseil and Jabłecki, 2011a; Gray et al., 2013; Nils Mæhle, 2021). Given the influence that the indicators resulting from the evolution of interest rates on the money market have on the cost of lending throughout the economy, the need to keep the volatility of this market under control is obvious.
At the same time, the very important role of these instruments less familiar to the general public is the absorption or provision of liquidity by the central bank in the very short term (one day). They contribute, along with many other instruments, to the actions of the central bank aimed at ensuring an adequate level of liquidity in the financial system, which is a very important factor for its proper functioning, both during normal and turbulent times. The onset of the pandemic crisis has shown once again that any endogenous / exogenous tension or shock that manifests itself in the economy influences the evolution of liquidity in the financial system, even when it is robust and not directly affected in the first instance.
The interest rate corridor system for permanent facilities also serves to signal the general direction of monetary policy. It contributes to maintaining money market interest rates in a reasonably close range around the monetary policy rate, given that the close relationship between the monetary policy rate and market interest rates is an important factor in the transmission of monetary policy. Through the interest rate corridor mechanism, the central bank generates a more efficient policy signal, as market rates follow the key interest rate more closely.
The above details, even if they may sometimes be too technical for the general public, show that the NBR’s use of the interest rate corridor instrument is not a marginal action, meaningless or ineffective, but an important lever with broad implications for the financial market and economic mechanisms.
At the monetary policy meeting on November, 9th corroborating the decision to increase the monetary policy rate by 0.25 percentage points with that to increase the amplitude of the interest rate corridor by another 0.25 percentage points the NBR’s Board has in fact applied a significant “de facto” strengthening of the monetary policy stance, with the central bank maintaining the firm control over money market liquidity.
In Romania, existing money market conditions in the current period are likely to contribute to the effectiveness of the measure to increase the amplitude of the corridor. As we know, the liquidity situation changes from day to day depending on the multitude of operations carried out by commercial banks (as a result of transactions made for their customers or in their own name), the Ministry of Finance or the central bank. The interconnection with the capital market and the foreign exchange market is also likely to influence liquidity in the money market. At the end of October, the Romanian money market was characterized overall by the prevalence of daily liquidity deficits. Under these conditions, the initiation of the normalization of the interest rate corridor contributed to an increased strengthening of monetary policy and to maintaining a reduced volatility of interest rates. Therefore, the measure was both useful and timely, given the conditions of the money market and their possible short-term evolution.
In the context of the complex economic situation generated by the short-term implications and unpredictable medium and long-term transformations of the pandemic crisis, all central banks use a multitude of tools to calibrate the impact of monetary policy on the economy as efficiently and as focused as possible. Most central banks that contributed data to the annual “Monetary Policy Benchmarks 2021” report published by the Central Banking Institute use an interest rate corridor system (18 out of 35 respondents). These include central banks of countries in the region such as Poland, Hungary, and the Czech Republic. Moreover, the interest rate corridor system is mainly used in emerging economies, as opposed to a number of advanced economies (e.g. the US) which after the global financial crisis favored the use of a floor system (Cap, Drehmann, and Schrimpf, 2020).
Although there is no consensus on the amplitude of the corridor, the international practice of central banks suggests the use of a narrow and symmetrical corridor, with interest rates for the two permanent facilities being equally spaced from the monetary policy interest rate. Specialized studies conclude that setting too large a corridor can affect market development and the transmission of monetary policy signals. A wide corridor discourages the intermediation of reserves through the central bank and can lead to relatively high “overnight” interest rate volatility, which would complicate banks’ liquidity management and discourage trading, making it riskier for them to rely on the market for fine-tuning the level of reserves (they may be inclined to “self-insure” by hoarding liquid assets and predominantly short-term loans – Bindseil and Jabłecki, 2011b). On the other hand, a too narrow corridor could in turn have a trade-reducing effect, even if its overall effects would be less worrying. Higher interest rate levels and the existence of other mechanisms for absorbing volatility may justify the existence of a wider corridor, including because interest rate adjustments tend to be higher in absolute terms the higher the interest rate level.
In Romania, we have had since May 2008 and until now a symmetrical corridor formed by the interest rates of the two permanent facilities, whose amplitude has been reduced in several stages from 8 percentage points to 2 percentage points (one percentage point above and one below the monetary policy interest rate, respectively) prior to the outbreak of the coronavirus pandemic. In March 2020, as part of the package of measures aimed at mitigating the impact of the coronavirus pandemic on the Romanian population and companies, the symmetrical corridor formed by the interest rates of the permanent facilities around the monetary policy interest rate was reduced to ± 0.5 percentage points. The gradual normalization of the corridor amplitude, after entering a new cycle of strengthening monetary policy (as a result of the evolution of inflation and taking into account the premises of economic recovery), is a natural evolution for which a first step was taken during the NBR’s monetary policy meeting at the beginning of November, the corridor being extended to ± 0.75 percentage points.
A relatively similar evolution during the period since the outbreak of the pandemic crisis may be observed for other countries in the region. For example, in the first part of this year, the Czech National Bank used an amplitude of the corridor of + 0.75 / -0.20, which was adjusted in several stages, starting in June, and returned to the standard size of +/- 1 percentage point in September. In the case of the National Bank of Hungary, from an initial configuration of + 1.25 / -0.65 percentage points around the monetary policy interest rate, the amplitude of the interest rate corridor has increased close to the standard, to ± 0.95 percentage points. In October, the National Bank of Poland adjusted the amplitude of the corridor formed by the interest rates of the permanent facilities around the monetary policy interest rate to ± 0.5 percentage points, compared to + 0.40 / -0.10 percentage points previously. So we see that also in the case of these three central banks, with which we often compare ourselves, the corridor was modified in response to the initial impact of the pandemic crisis, and was later normalized. At the same time, we notice that at present they also practice a symmetrical corridor (even if during the crisis it was asymmetrical), of a size comparable to the one currently applied by the NBR.
In the application of economic policies there are many situations in which a careful balance of the possible positive and negative effects is needed, in the short term versus the longer horizon. For monetary policy, these choices become more evident when there is a need to regain the room for maneuver, through a normalization that follows a relaxation in response to a crisis. Central banks are fully aware of the need to strike a balance between the need to combat the persistent components of inflation, without overreacting by addressing those components that are transitory and / or exogenous and without prematurely discouraging the economic recovery still under uncertainty and short-term risks. These considerations are reiterated by the European Central Bank, the US Federal Reserve, the Bank for International Settlements or the International Monetary Fund. Obviously, a careful analysis and adaptation of the conduct of monetary policy according to international / regional circumstances and the particularities of the local economy is needed (Carsten, 2019). A recent analysis by the Bank for International Settlements shows that the challenges associated with the process of normalizing monetary policy in emerging economies are particularly numerous and complex in the current conditions of fragile fiscal positions, rising debt levels, structural vulnerabilities, inflation (temporarily) above assumed targets, uncertainties regarding economic growth in the next period, risks of cross-border financial and economic spillover effects as a result of potential changes in the approach of monetary policy in advanced economies, high valuations of financial assets and real estate, etc.
That is why the central banks in these economies are adapting the pace of normalization of monetary policy to local conditions and seek to act with as wide a range of instruments as possible. Decisions on the pace and timing of monetary policy strengthening actions are now, as has often been the case in the past, a delicate act of balancing the associated positive and negative effects (“balancing act”). In the Bank of International Settlements’ assessment, it may be useful for emerging economies central banks to use a broad set of policy instruments, including macro-prudential instruments, to manage the many divergent pressures manifested internally or globally, in a combination which varies depending on the institutional, economic, and financial vulnerabilities and particularities.
The use by the NBR of the permanent facilities and the related interest rate corridor in complementarity with the change in the monetary policy interest rate is one of the latest examples of adaptation to specific local conditions and careful calibration, which takes into account that delicate and difficult balancing of the inherent positive and negative effects, to which the Bank for International Settlements and other similar bodies refer.
In a world dominated by uncertainty, correct understanding, temperance, and flexibility are paramount to responding to the multiple risks that arise.
 Bindseil, U. și Jablecki, J. (2011), “A Structural Model of Central Bank Operations and Bank Intermediation,” ECB Working Paper Series No. 1312.
 Bindseil, U. și Jablecki, J. (2011), “The Optimal width of the Central Bank Standing Facilities Corridor and Banks’ Day-to-day Liquidity Management”, ECB Working Paper Series No. 1350
 Nils Mæhle (2021), “Monetary Policy Implementation: Operational Issues for Countries with Evolving Monetary Policy Frameworks”, IMF Working Paper Series No.20/26
 Central Banking (2021), “Monetary Policy Benchmarks”
 Cap, A., Drehmann, M., și Schrimpf, A. (2020), “Changes in monetary policy operating procedures over the last decade: insights from a new database”, BIS Quarterly Review
 Gray, S., Karam, P., Meeyam, V. și Stubbe, M. (2013), “Monetary Issues in the Middle East and North Africa Region: A Policy Implementation Handbook for Central Bankers”, IMF Departmental Paper No. 13/1
 Carstens, A. (2019) speech at the “Annual General Meeting of the BIS”, Basel, 30 June 2019, available online at https://www.bis.org/speeches/sp190630.htm