Economic Analysis - Disinflationary Pressures To Delay Tightening - JUNE 2017


BMI View : We have revised down our forecasts for the trajectory of Romanian inflation and policy rates in 2017 . However, we still project the NBR to hike interest rates by the end of 2017 to counteract the build-up of inflationary pressures stemming from robust domestic growth .

Driven mainly by rising commodity prices, Romania's consumer price index (CPI) returned to positive growth of 0.1% y-o-y in January 2017. This marks an end of the country's two-year deflationary period, which saw annual price growth coming in at -0.9% in 2015 and -0.5% in 2016. Looking ahead, Romania's inflation will remain below that of Central Eastern European (CEE) peers in 2017, largely due to tax and administrative prices cuts. Moreover, while base effects from supply-side pressures will gradually fade towards the end of the year, further tailwinds to inflation will be brought about by strong economic growth and rising inflation expectations, which in turn will direct the central bank to adopt a tighter monetary policy by the end of 2017.

Inflation Trending Higher
Harmonised Index of Consumer Prices, % chg y-o-y
Source: Eurostat, BMI

Persistent Disinflationary Pressures in 2017

Although we continue to project a gradual build-up of inflationary pressures, we have revised downwards our inflation forecasts for 2017. We now project end-of-period inflation to stand at 2.5%, and for average inflation to come in at 1.5%, down from previous projections of 3.0% and 1.6%, respectively. Two main factors underpin our adjustments. Firstly, we expect stronger disinflationary pressures throughout 2017 on the back of a 1 percentage point (pp) VAT tax reduction in January 2017 and several administered price cuts implemented over the last quarter of 2016. Secondly, our view is informed by weaker-than-expected developments in services and core inflation, despite the robust performance of the economy in the recent quarters which saw annual real GDP growth in 2016 at 4.8%. Core inflation saw a more subdued uptick compared to the headline figure, standing at 0.0% in January 2017, while month services prices fell further into contraction, coming at -0.6%, down from -0.4% in December 2016.

Weaker Momentum
Romania - Core Inflation, Administered Prices & Services Inflation, % chg y-o-y
Source: Eurostat, Bloomberg, BMI

On the back of our inflation forecast adjustments, we now expect less and delayed key rate hikes for this year. We project the key rate to end 2017 at 2.25%, 0.25pp below our previous estimates, while we maintain our projection at 3.0% for 2018. This is in line with the Central Bank of Romania's (CBR's) more dovish tone and forecasts. At the last monetary policy meeting held in February, the CBR kept the key rate unchanged at 1.75%, marking a stall of 22 consecutive months, and maintained the corridor of interest rates on its standing facilities at +-1.50 percentage points. The CBR also revised its inflation projections for headline and core CPI in Q417 down by 0.4pp and 0.6 pp, respectively, compared to its November forecasts. The bank now projects inflation to re-enter the 2.5% +- 1pp target corridor only after the third quarter of 2017, rather than in the first half of the year, as previously estimated.

The CBR Expects More Subdued Growth
Romania - CBR Inflation Forecasts & Inflation Target
Source: CBR, BMI

That said, we believe a tighter monetary policy by end-2017 will be necessary to counteract the build-up of inflationary pressures which will be driven primarily by domestic factors. In particular, the trajectory of core inflation will remain the main factor underpinning our view on Romania's inflation outlook, given that this measure best gauges the trajectory of long-term price growth. Mainly, we expect stronger core inflation to be brought about by the country's robust economic growth ( see 'Growth Slowing But Still An EU Outperformer ' , February 24). Moreover, we expect further upward pressures to be driven by the country's tightening labour market, which will continue to drive robust wage growth, and the government's expansionary fiscal policy which foresees further wage increases and a boost in social spending. Rising inflation expectations are also evident in markets, which in February 2017 saw the spread between 10- and two-year government bond yields reach a historic high.

Markets Expecting A Tighter Monetary Policy Soon
Romania - Spread Between 10-Year & 2-Year Government Bond Yields, pp
Source: Bloomberg, BMI