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Forget about positive real interest rates!

Published at: 05-07-2019

Posted on: July 5th, 2019 by RaduC No Comments

In a recent public intervention at the start of its new term, the Romanian Governor of the Central Bank, Mugur Isarescu, gave us some interesting insights into the local FX and money market developments. Practicing what he calls “FX intervention using moral suasion”, he warned that the NBR will not allow the Romanian local currency (RON) to appreciate even if that would help pushing inflation down.

The advantage would be cancelled out by the threat of cheaper imports and deterred exports which could only generate a faster increase in trade and current account deficits. The concern is that a high deficit financed mainly by speculative capital inflows will make it more difficult to adjust later in a crisis and would result in a shock similar to that in 2008.

The announcement in connection with the exchange rate and hot money inflows have another, possibly more serious implication.

The NBR will refrain from increasing the central bank policy rate for quite some time and, consequently, banks` commercial interest rates will stay put.

The reason is the already high interest rate differential between interest rates in the Eurozone and the US in particular which make speculative investments in Romania attractive. These investors get their money by raising money in low-interest currencies and investing them in Romania at a higher rate, with the FX risk attached. They are all the more encouraged in their gamble by the stability of the RON exchange rate propped up by the NBR itself, stability to be pursued willy-nilly going forward, given that a weaker RON would put further pressure on an already rising inflation.

So here we are, in a situation where, sadly, the NBR`s monetary policy is no longer predominantly underpinned by national inflation estimates, but rather linked to the expected monetary policies of the main central banks. And they are bracing up for a more relaxed monetary policy as inflationary pressure in the countries under their jurisdiction is very low and recession is right around the corner.

This is why I believe that we should look with concern at the domestic inflationary pressures fuelled by the budgetary policy since they will not be dealt with an appropriate monetary policy. Let us not forget that the governor`s statement comes just a few months after the NBR changed its 2019 inflation rate forecast by 37% to exceed the inflation target. Under these circumstances, Governor Isarescu is eager to reassure us that Romania will not experience “galloping inflation”. What does that mean? It means that the inflation rate will not exceed 10%. Cold comfort…

In conclusion, if we continue to boost consumption, there is an increased likelihood of having real interest rates decoupled from inflation in the medium term. In a negative way.

Have a nice weekend!

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