Romanian base interest rate rises as inflation accelerates

• After a surprising no policy change in its monetary policy meeting in April the National Bank of Romania (NBR), the central bank, raised its main monetary policy rate by 25 basis points for the third time this year on 7 May.
• While the acceleration of inflationary pressures was expected, another hike was needed to keep it in line with the forecast.
• We have been forecasting three hikes in 2018 and now expect a steady rate over the remainder of the year. With such monetary policy tightening we project that annual inflation will still accelerate through the first half of 2018, but will decelerate more significantly in the latter half of the year.

For the third time in 2018, the National Bank of Romania (NBR) has increased its main monetary policy rate by 25 basis points. The rate was increased from 2.25% to 2.5% at the NBR's meeting on 7 May, following 25-basis-point increases at the January and February meetings. Before these 2018 actions, the main policy rate had not been increased since late 2008, and not been changed at all since May 2015. In addition to adjusting the main policy rate, the NBR raised the deposit facility rate by another 25 basis points to 1.5% and increased the lending (Lombard) facility rate also by 25 basis points to 3.5%. Minimum reserve requirements were left unchanged.

In its press release announcing the measures, the NBR pointed out that currency inflation in March increased in line with its forecast. The bank almost did not change the projected path of the annual inflation rate from that in the previous inflation report. It was raised by 0.1 percentage points for the end of this year and downwards by 0.1 percentage points for the end of next year. According to the assessment of the central bank, inflation accelerated this year mostly because of supply-side factors, such as higher fuel prices. However, core inflation had been edging up as well. Adjusted CORE2 annual inflation continued rising to 3.0% in March from 2.9% in February. This, according to the bank, shows excess aggregate demand in the Romanian economy and is a reflection of rising labor and other production costs. Some effects were magnified by changes in the leu exchange rate. The bank also noted that inflation expectations continued to rise.

Outlook and implications

The NBR has a 2.5% inflation target, within an acceptable band of plus or minus one percentage point. Annual inflation has been outside that band throughout 2018 so far and reached 5% in March. We expect inflation to remain outside the band until the end of 2018, but to moderate somewhat after that. Higher commodity and administered prices, statistical effects from tax changes, and domestic price pressure - which drive core inflation - will all contribute to high inflation rates. Pro-cyclical fiscal policy, tightening of the labor market, and rising labor productivity will propel wages and prices.

We expect that, with the rate now at 2.5%, the NBR will pause its tightening to observe the effect on inflation. As price growth begins to decelerate, the NBR will maintain its policy rates until the end of the year. In the January decision, the NBR had stated that it did not expect that it had embarked upon a long tightening cycle. The primary risk to our interest rate outlook is that the NBR may be more aggressive than it initially indicated. Nonetheless, we do expect the tightening to help ease inflationary pressures overall, enabling price growth to decelerate later in the year. Moreover, more aggressive tightening would be somewhat out of step with expectations for the European Central Bank in 2018 and 2019. The NBR has also recently implemented liquidity absorption measures, and more substantial rises in base rates could have a negative effect on domestic investment, which has recently started recovering. Therefore, we do not anticipate that the central bank will further raise rates unless inflation accelerates beyond the central bank's forecast. This risk remains, not least because of rising oil prices, but our inflation forecast for 2018 is currently close to the central bank's.