Monetary policy: "Wait and see" remains a good strategy

August 2011

IONUT DUMITRU - Chief Economist / Treasury and Capital Markets NICOLAE COVRIG - Financial Analyst / Treasury and Capital Market RAIFFEISEN BANK S.A.

Inflation outlook proves to be worse than initially expected

Monthly inflation rates in the ending part of 2010 and in the first half of this year were larger than expected. Low figures were recorded only in May (+0.2% mom) and June (-0.3% mom). As a result, current annual inflation rate (7.9% yoy as of June) is much above the level we (and the market, and the central bank) forecasted nine months ago. In this context, the end-2011 inflation forecasts were revised up this spring. For instance, we revised end-2011 inflation forecast to 5.3% yoy from 4.5% yoy initially. At the beginning of May, the NBR said that it expects the inflation rate to be at 5.1% yoy at the end of the year, sharply up from 3.6% yoy it had forecasted in February.

Supply side shocks explain the high inflation rate

Clearly, the inflation outlook at the moment is worse than initially expected. Inflation rate in Romania remains by far the highest among the EU member countries. However, the high level of the inflation rate is mainly the result of increases in taxes (especially VAT) and of strong adverse supply side shocks.

Firstly, increase in VAT from 19% to 24% has the largest contribution to the current annual inflation rate. We think that the contribution is close to 3.5 percentage points out of the total inflation rate of 7.9% yoy as of June. When removing the impact of the last year’s increase in VAT, the annual inflation rate in Romania is not by very much higher compared to the levels recorded in the other EU member countries. In fact, when the impact of the VAT hike would fade out in July, the annual inflation rate would fell towards 5.2% yoy.

Secondly, there was strong adverse impact on the inflation rate from the sharp increase in volatile prices of foods and fuels. Growth rate of commodity and agri-food prices accelerated in the second half of 2010 and it has become visible in higher final consumer prices worldwide (especially for gasoline). Romania is not an exception. Prices for fuels, fruits and vegetables increased the most over the last year. Three very important remarks should be made with regards to the dynamics of food prices:

■ The increase in food prices in Romania has been in line with developments in the other countries in CEE (see comparative charts). Clearly, growth rates in prices for vegetables and fruits are the highest in case of Romania. But in case of other categories of food products, Romania is not in the top of price increases (prices grew faster in many other countries).

■ The demand is not relevant when supply side shocks are very large. Consumption demand was weak in Romania as decrease in real disposable income made consumers to restrain spending. But even in this situation food and energy prices still have increased. The expectations were that weak demand should limit the advance in prices.

However, a closer look at the experience of the other EU member countries shows some similarities. Consumption demand was also very weak in countries likes Latvia, Lithuania, Estonia and Hungary, but food prices rose sharply in all these countries.

■ The high share of foods in total HICP/CPI basket makes Romania’s headline inflation rate very vulnerable to adverse moves in food prices. In Romania, foods accounts for 33.1% of the HICP/CPI basket, which is the highest share among the EU member countries. So, even though increases for different categories of food prices were comparable with developments in other countries, advance in food prices had a much important impact on the headline inflation rate in Romania because of the very high share of these goods in the consumption basket.

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