Preparations and Prerequisites for the Introduction of Inflation Targeting in Romania

Presentation by Deputy Governor Cristian Popa National Bank of Romania

NBR-BoE Conference on Inflation Targeting: International Experience and Bucharest, 30 March 2005

Romanias Prospects

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Outline
1. 2.
Recap: Context and Initial Specifications Internal Preparations
2.1 Organizational issues 2.2 The Policy-Making Process 2.3 Forecasting 2.4 Communication issues

3.

Prerequisites for Inflation Targeting

3.1 Absence of Fiscal Dominance 3.2 International Comparisons

4.

Steps Ahead
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

1. Recap: Context and Initial Specifications

Inflation targeting mentioned in Romanias Medium-Term Strategy
for Economic Development (2000), confirmed in PEPs (2002 and beyond)

Initial specifications:

(i) target specified in terms of CPI; (ii) mid-point with band (some tolerance for undershooting target); (iii) annual targets w. multi-period perspective (initially two years); (iv) flexible interpretation of inflation targeting (esp. coexistence w. managed float regime); (v) existence of few ex ante defined exceptions conditional to attaining the target; (vi) joint announcement of target with government
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.1 Organizational Issues

Task force set up to implement the IT framework, led by
coordinating DG Monetary Policy Department Research and Publications Department Macroeconomic Modeling and Forecasting Department framework Centralized database Data monitoring & reporting Expectations survey Near-term forecasting of key variables Medium-term forecasting model, consistent with achieving multi-period inflation targets
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

Development of a detailed quarterly macroeconomic forecasting

NATIONAL BANK OF ROMANIA Preparing the Introduction of Inflation Targeting

Data management
Satellite models NTFs for domestic exogenous variables (RPD, MPD and MMFD) DATA FOR THE CORE MODEL Satellite models (MMFD) Expert judgment

DETAILED MACROECONOMIC DATA raw historical data for domestic and external variables updated on a regular basis near-term forecasts for external variables NEAR-TERM FORECASTS (NTF) domestic and external variables exogenous for the core model

CURRENT POSITION OF THE ECONOMY (initial conditions for the core model) equilibrium values for relevant variables and their medium term profile

Central NBR database

Cut- off date

External sources Consensus Forecasts

The core model (MAMTF)

QUARTERLY MODEL PROJECTIONS 3rd party forecasts (surveys) inflation and relevant variables

Conference on Inflation Targeting Targeting Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.2 The Policy-Making Process

Role of the NBR Board

Exceptional initial involvement in model specification, starting Final decision-making body Focuses on how to best employ forecasts in policy making In practical terms:

conditions (in order to foster ownership/understanding: successful dialogue with the model)

identifies alternative scenarios to consider or special issues to be examined from the viewpoint of strategy (big decisions); these are then run through model again for consistency judges how the path for the policy interest rate should be adjusted to account for uncertainties and risks
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Role of the Monetary Policy Committee (MPC)

Institutionalized analytical forum at staff/executive

management level

Critical focus on ensuring that all relevant information is

brought to bear on the forecasts

In practical terms:
responsible for reviewing assumptions on initial conditions for the forecasts, including the outlook for exogenous variables reviewing the projections and formulating policy recommendations for the Board, including analyses of their technical implications
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Quarterly Forecasting & Decision Schedule

Time T-57 T-51 Event Task Force First issues meeting Task Force Second issues meeting MPC regular monthly meeting Board regular monthly meeting T-34 T-27 T-23 Task Force meeting Task Force meeting MPC meeting Model meeting Other projection details Policy review and recommendation Policy review and decision NearNear-Term Forecasts (NTF) Initial conditions, equilibrium conditions and exogenous variables Initial conditions, equilibrium conditions, exogenous variables and NTF Final projection meeting Forecasts and risk scenarios Monetary Policy Decision Forecasts and Inflation Report Report sent to MPC Discussion of forecasting cycle and Inflation Report Report Discussion & Eventual Adoption of Inflation Report Report
Bucharest, 30 March 2005

Details

Start of Forecasting Cycle T-18 T-15 T-10 T T+3 T+6 Task Force meeting MPC monthly meeting Board meeting Inflation Report MPC meeting Board meeting

Inflation Targeting: International Experience and Romania Romanias Prospects

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.3 Forecasting
Based on formalized models and expert judgment Two types of modeling approaches:
Estimation approach at the short-run horizon Calibration approach at the medium-term horizon

Final forecast integrates information from short-term models,

medium-term model and expert judgment

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.3.1 Near-Term Forecasting Framework

Two-quarter horizon at present A set of methods (one model approach is risky) Economic theory as a basis of analysis, but applied to
statistical data (estimation vs. calibration) variables

Tool for simulating the impact of changes in exogenous Used for analysis and for establishing the initial conditions for
the QFM
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Near-term Inflation Forecasting Two methods: Expert judgement forecast for CPI components ARMAX model for the main CPI inflation components (yoy data,
monthly frequency) Food Non-food excluding regulated and fuel prices Services excluding regulated prices Exogenous variables: EUR/ROL and EUR/USD exchange rates, net wages, regulated prices, fuel prices

The forecast presented to the MPC = weighted average of the results

provided by the two methods (with 0.65 weight given to the ARMAX model)
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Near-term GDP Forecasting

Small semi-structural model (qoq)

Behavioural equations for household consumption, gross Exogenous variables: EUR/ROL and EUR/USD exchange rates, public
consumption, net wages, regulated prices, fuel prices, 3M Euribor, euro area GDP, HICP fixed capital formation, exports, imports and core inflation

OLS and 2SLS estimation with error correction mechanism

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.3.2 Medium-Term Forecasting

History Assembling the Model for Analysis and Medium-Term Forecasting
(MAMTF) started in mid-2004

Significant progress achieved, with technical assistance support from

two IMF missions and bilateral exchanges/expert visits with the Czech National Bank (MAMTF conceived in similar fashion to Czech QPM) integration of short-term and expert information; currently in second dry run

Two forecasting dry runs to test MAMTF adequacy and the functional

First-pass calibration of MAMTF based on priors discussed by the

Banks Board
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

General characteristics of MAMTF

Model open to continuous improvement, while maintaining

the core structure

Small semi-structural calibrated model with a New-Keynesian

core (ST and MT non-neutrality) long-run equilibrium

Economy assumed to converge to well-defined and stable Deviations from trends the gaps - reflect cyclical behavior
of the economy, while trends are analogous to steady-state values (primarily assessed on inflation neutrality)
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Core structure of MAMTF

Core inflation determined by its structural persistence, agents expectations,
output gap, and import price inflation

Output gap or excess demand factor determined by its own persistence and real

monetary conditions, incl. gaps of real (bank) interest rates and real exchange rate including a risk premium

Exchange rate determined according to uncovered interest parity relationship Monetary policy behavior (as implied by flexible inflation targeting) described by a

forward-looking policy interest rate rule that reacts to deviations of inflation from target, the output gap and excessive interest rate volatility

Agents expectations modeled as hybrids of backward-looking (inertial) and

forward-looking (model-consistent) expectations

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Specifics of the MAMTF transmission mechanism

Low sacrifice ratio (but may vary over time, according to progress
of disinflation)

Expectations channel quite significant for monetary policy direct

influence on inflation

Exchange rate channel also important, especially for speed of

disinflation (two channels: direct, via pass-through; indirect, through influences on real sector and asset portfolios)

Aggregate activity (output gap) channel relatively less effective at

present, but crucial for ensuring continuity of disinflation process deposit and lending rates

Monetary policy impulses intermediated by relatively sluggish bank

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Increasing role of policy rate in influencing inflation

R e s p o n s e of c or e i n fl ati o n t o m o n et ar y p olic y in d u c e d s h o c k s S a m p l e: J u n e 1 9 9 7 - D e c e m b er 2 0 0 0
R e s p o ns e t o a r e al i nt e r e s t r at e g a p s h o c k
.008 .002 .001 .004 .000 -.001 .000 -.002 -.003 -.004 -.004 -.005 -.008 2 4 6 8 10 12 14 16 18 20 M o nths 22 24 -.006 2 4 6 8 10 12 14 16 18 20 M o nt hs 22 24

R e s p o n s e of c o r e i n f l at i o n t o m o n et a r y p ol i c y i n d u c e d s h o c k s S a m p l e: S e p t e m b e r 2 0 0 0 - N o v e m b e r 2 0 0 4
R e s p o n s e t o a r e al i nt e r e s t r at e g a p s h o c k

Vari anc e dec o m positi on of c ore infl ation Sa mple: J une 1 997 - D ec e mb er 2 00 0
90 80 70 60 50 40 30 20 10 0 5 10 15 20
Months

Vari an ce dec om position of cor e inf l ation Sa m ple: Septe m ber 20 00 - N ov e m ber 20 04
70 Contrib ution of sh ocks ( % of total varian ce)

Contrib utions of sh ocks ( % of t ot al varianc e)

60 50 40 30 20 10 0

10

15

20

Months

Outp ut g ap Real interest rat e gap

Real exch ang e rat e gap Core inflation

Outp ut g ap Real interest rate g ap

Real exch an g e rate g ap Core inflation

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.3.3 The forecasting process

Role of near-term forecasting
Covers short end of forecast horizon Shapes the initial conditions of the forecast (In the future) Serves as cross-check for final forecast

Role of expert judgment

Flexibility of MAMTF allows direct incorporation of expert input (incl. survey-based information) Forecasts of effects of anticipated exogenous events (e.g. capital account liberalization) Forecasts of variables not explicitly modeled (e.g. fiscal stimulus) Model forecasts can be tuned if unrealistic Integrates all information in a consistent way Generates an interest rate path which can serve as policy guideline Can be used to generate risk scenarios, analyze consistency of alternative scenarios
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

Role of medium-term model

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

Flow of information in the forecasting process at the National Bank of Romania

Near-term forecast

Near-term models NTF Inflation, GDP, EUR/ROL etc. and expert forecast Medium-term (core) model

Final medium-term forecast

Assessment of initial conditions and medium-term trends

Trends & Gaps

Exogenous variables forecasts

Anticipated shocks, fiscal impulse, etc.

Tuning

Uncertainty Expert judgment

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.4 Communication issues

Restructuring of the existing inflation report Policy made more transparent Supporting external communication

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.4.1 The New Inflation Report

Plays the central role in the communication strategy under IT To be published quarterly, reflecting the forecasting cycle; first
quarterly report (2005Q1) expected July, also serving to emphasize multi-period preoccupation for attaining the inflation targets

Based on the same information set used in the forecasting process Compared to existing 6-month Inflation Reports: (i) more timely
publishing; (ii) transparent inclusion of NBR inflation forecast, policy decision, detailed risk assessment; (iii) balance favors forward-looking analysis over backward-looking reporting; (iv) will replace a substantial portion of analysis currently included in NBR Annual Reports, some streamlining of monthly bulletins also a result rounds, for purposes of internal analysis
Bucharest, 30 March 2005

Unpublished draft inflation reports for the two dry-run forecasting

Inflation Targeting: International Experience and Romania Romanias Prospects

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.4.2 Increased Policy Transparency

Increased frequency and quality of communication with
public on policy issues

Prior announcement of calendar for policy-related Board

meetings

Press releases on contents of between-forecast meetings

and on the monetary policy decisions

Prior announcement of confirmation of fully-fledged

implementation of IT regime, with details on bandwidth, formalized exceptions, etc.

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

2.4.3 Supporting external communication

The NBR website will be re-designed to allow easier access to
policy related information and to include background information on inflation targeting

Dedicated briefings on benefits of IT and the related policy

process to be organized

Brochure series targeted for broader audience Background papers to be published Conferences, interviews, public speeches
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

3. Prerequisites for Inflation Targeting

3.1 Absence of Fiscal Dominance (dep var. IINTER = (BUBID3M + BUBOR3M)/2)
8 12 8 4 0 0 -4 -8 -8 -12 -16 1999 2000 2001 2002 2003 2004 1999 2000 2001 2002 2003 2004 4

-4

-12

Recursive log NBR steriliz. flow estimates 2 S.E.

Recursive log MoF debt issuance <=1Y estim. 2 S.E.

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

V a ri a n c e D e c o m p o s i ti o n o f I I N T E R
120 100 80 60 40 20 0 1 2 3 4 5 6 7 LFLUX 8 9 10 11 12

II N T E R

LVOL MOF

Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005

120 100 80

percent of GDP

3.2 International Comparisons Credit to Non-Government*

112.0 94.4 76.0 71.7 113.8

61.5 60 40 23.0 20 0 MX (1999) 31.7 49.3 37.6 16.4

58.2

23.9 8.3 SE (1993) IS (1992) AL (2004)** UK (1992) ZA (2000)

17.5

Source: EUROSTAT, NBR, NIS, IMF

*) at the time of shifting to inflation targeting **) intends to adopt inflation targeting ***) to shift to inflation targeting in 2005

RO (2004)***

PL (1998)

TH (2000)

BR (1999)

NZ (1990)

UA (2004)**

CZ (1997)

HU (2001)

CL (1990)

Bank Assets*
250 200 150 100 56.0 50 0 AL (2004)** UA (2004)** RO (2004)*** CZ (1997) HU (2001) BR (1999) NZ (1990) TH (2000) PL (1998) UK (1992) IS (1992) ZA (2000) 69.1 53.9 136.0 138.0 127.2 104.4 92.5 49.8 39.4 38.3 percent of GDP 229.0

Source: Websites of central banks and national statistics institutions

*) at the time of shifting to inflation targeting **) intends to adopt inflation targeting ***) to shift to inflation targeting in 2005

Stock Market Capitalisation*

180 160 140 120 100 80 60 40 20 0 CZ (1997) HU (2001) MX (1999) BR (1999) NZ (1990) CL (1990) TH (2000) PL (1998) UK (1992) IS (1992) SE (1993) ZA (2000) 24.1 12.9 20.1 52.6 45.0 42.9 32.1 45.0 24.4 20.0 0.9 UA (2004)** RO (2004)*** 17.6 86.5 percent of GDP 160.0

Source: EUROSTAT, NIS, BSE, RASDAQ

*) at the time of shifting to inflation targeting **) intends to adopt inflation targeting ***) to shift to inflation targeting in 2005

Insurance Premia*
18 16 14 12 10 8 6 4 2 PL (1998) CZ (1997) HU (2001) 0 2.9 2.9 2.8 2.0 1.7 2.5 6.1 3.5**** 1.3 SE (1993) ZA (2000) RO (2004)***
****) 2003

percent of GDP 16.9

MX (1999)

BR (1999)

TH (2000)

Source: EUROSTAT, Swiss Re, ISC, NIS

*) at the time of shifting to inflation targeting **) intends to adopt inflation targeting ***) to shift to inflation targeting in 2005

UA (2004)**

Fiscal Surplus/Deficit*
2 0 2 4 6 8 10 12 14 RO (2004)*** AL (2004)** UA (2004)** HU (2001) CL (1990) MX (1999) CZ (1997) TH (2000) BR (1999) NZ (1990) PL (1998) UK (1992) SE (1993) ZA (2000) IS (1992) -9.9 -9.2 -11.4 -4.4 -4.4 -6.4 -5.4 -1.3 -2.2 -1.1 -2.2 -1.8 -3.0 -1.1 percent of GDP 0.7

Source: EIU, MPF, NIS

*) at the time of shifting to inflation targeting **) intends to adopt inflation targeting ***) to shift to inflation targeting in 2005

NATIONAL BANK OF ROMANIA Preparations and Prerequisites for the Introduction Introduction of Inflation Targeting in Romania

4. Steps Ahead
Additional scope in data reporting, surveys: integrating
reliable information & expectations regarding housing & financial assets Improvements in near-term forecasting and integration into decision-making: ARMAX, expert judgment Improvements in MAMTF: (i) refining calibration; (ii) adding extra wrinkles; (iii) interaction with additional blocks (satellite sub-models): external accounts, fiscal; (iv) extending range to 6 and 8 quarters ahead Transparency & communication: improvements in content of QIR; briefing sessions on regular basis; possible publication of minutes/voting records
Inflation Targeting: International Experience and Romania Romanias Prospects Bucharest, 30 March 2005