Sofia, 3-4 October 2005

1. 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

2. 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 NBR’s 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

3. 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. M&LT External Debt 10. Public Debt Stock 11. Inflation Rate and Interest Rates 12a. Non-Government Credit 12b. Total Credit and Non-Government Credit

4. 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

5. 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)

6. 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

7. 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

8. 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

9. 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

10. 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

11. VI. Features of NBR’s 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)

12. Features of NBR’s 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 NBR’s responsibility for reaching the inflation target (escape clauses) • Joint announcement of inflation targets by the NBR and the government

13. 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

14. 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

15. Near-term forecast Near-term models (ARMAX) and Expert forecast Final medium-term forecast NTF Inflation, GDP, EUR/RON etc. Medium-term (core) model Assessment of initial conditions and medium-term trends Trends & Gaps Anticipated shocks, fiscal impulse etc. Tuning Exogenous variables forecasts Uncertainty Expert judgement Quarterly Forecasting & Decision-Making Process (2) Flow of information in the forecasting process at the National Bank of Romania

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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-forecastmeetings and on the monetary policy decisions

25. CHARTS

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29. 4. 22 Sep. 05

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37. 12b.