Unfortunately, this decline came to an abrupt halt recently, and year-on-year inflation increased to nearly 7 percent in October, driven by sharp increases in food and services prices. While outside factors – such as rising world food prices – have been at work, there is no question that domestic factors – including an overheated demand and rising labor costs – are playing their part, as signaled by core measures of inflation. The National Bank of Romania (NBR) is now projecting that year-end headline inflation will be well above its 3-5 percent target band.
Rising inflation must be fought forcefully. Low and stable inflation benefits the entire economy, but it helps particularly those with low incomes – pensioners and low earners – who are most vulnerable to rising prices. The NBR has already developed a first line of attack by raising interest rates at end-October. But interest rate policy can only go so far. With a fully open external financial account in Romania, capital flows react quickly to a widening differential between domestic and foreign interest rates.
An effective response requires coordinated action on both monetary and fiscal fronts. Fiscal policy plays a particularly significant role in Romania: it controls directly about forty percent of the economy's spending; it sets public sector wages, which have a strong demonstration effect on private sector wage setting; it sets the minimum wage, which also affects the amount of social benefits; and it sets pensions, which influence the purchasing power of some 6.4 million pensioners. Thus, the appropriate policy reaction by the NBR, which may include further interest rate increases, needs to be supported by tight fiscal and prudent public-sector wage policies, both to lower inflation and to promote growth.
If the NBR is left alone to fight inflation, the resulting higher interest rates will affect the share of investment in GDP, and therefore future growth. As important, these higher rates will result in a stronger exchange rate appreciation and adversely affect the competitiveness of the economy. Therefore, a policy mix where both monetary and fiscal policy are tightened in the period ahead is also essential to contain external imbalances and minimize vulnerabilities in the banking sector.
Policy Conflicts or Complementarities?
In Romania, over the past few years, fiscal and monetary policies have not come into conflict. The result was that both inflation and long-term interest rates were brought down, while capital formation increased as a share of GDP. This favorable environment, if maintained, should boost growth for years to come and help Romanian incomes converge to levels in Western Europe.
But monetary and fiscal policies now seem to be moving in different directions, and could start effectively working against each other. In the face of higher expected inflation, the NBR raised interest rates by 50 basis points on October 31st, and may have to act sooner rather than later. This is consistent with the NBR's inflation targeting framework. Fiscal discipline, on the other hand, is expected to loosen in the period ahead. Not only are pensions to rise by over 40 percent cumulatively November-January and minimum wages by about 30 percent, but the overall fiscal deficit is estimated to widen significantly to 2.7 percent of GDP in 2008. Moreover, the IMF's conservative estimates suggest that the underlying fiscal position might be at least one percentage point of GDP weaker than indicated by the actual fiscal deficit-as the current spending surge has resulted in temporary revenue windfalls.
What can be expected from a combination of tight monetary and loose fiscal policy in the period ahead?
Lower investment: As the real interest rate increases, other things being equal, we would expect less real capital formation. Although the economy may continue to grow strongly in the short run, the effects of lower investment will be felt in lower longer-term growth.
Crowding out of exports: Capital inflows responding to interest differentials will tend to appreciate the leu. While this will help disinflation, the external current account deficit is bound to widen because of lower exports.
Shift to foreign currency borrowing: The interest rate differential will also increase incentives for foreign currency-denominated borrowing, and banks will likely oblige because they have ready access to foreign financing. Increasing the share of banks' foreign currency assets from the current level of 50 percent-without adequate currency risk hedging by borrowers-will make banks more vulnerable to exchange rate changes.
There is Still Time to Get Fiscal Policy Right
Romania is expected to grow by over 6 percent this year and next, and unemployment has fallen to 4-5 percent, with shortages starting to appear in certain labor skills. In this setting, an expansionary fiscal and incomes stance will represent an additional demand impulse to be offset by the central bank, which is already hard-pressed to lower inflation.
Periods of good economic performance provide opportunities for countries to insure themselves against harder times in the future – in Romania's case, for example, by building on the small general government surplus observed at end-October. Initially, it would be important to avoid the year-end fiscal splurge seen in 2006. And that would lay the ground for a very prudent fiscal policy in 2008: aiming for a smaller deficit than in 2007 and an increase in public sector wages strictly in line with expected inflation and productivity growth. While public wages should gradually rise – and have indeed been rising significantly – rapid increases that fuel inflation will negate their initial positive impact on living standards.
Admittedly, with elections coming up, it will be difficult for fiscal policy makers to do the “optimal thing”. But their leadership remains essential for restoring low and stable inflation. If a significant fiscal tightening is implemented in 2008, the IMF estimates that a moderate increase in interest rates will bring inflation back within the target band around mid-2008, without many adverse effects on investment and growth. If not, it may take longer to bring inflation down, and interest rates will need to increase by much more, affecting investment, growth, and the external current account deficit through a more appreciated exchange rate.
Fiscal and monetary policy complementarity will be required in the current circumstances to defend the longer-term interests of the most vulnerable in society. The good news is that there is still time to develop it.
Juan J. Fern