Money
Inflation is always and everywhere a monetary phenomenon
Florin Citu
June/July 2005
Milton Friedman, an American economist, showed that over a long period of time monetary policy is neutral. Although this statement might not say anything to a non-economist, it does have real implications for an economy. In layman’s terms, it says that you cannot use monetary policy to promote economic growth, because in the end (experience showed) you will just end up with higher prices and possibly higher unemployment.
But what does this have to do with Romania? Very
much, I would say. Especially since all everyone in the money market is talking
about is liquidity.
Central banks use different instruments to control money supply. In developed
economies they use bond markets. However, in developing economies this is
not an option most of the time; thus, central banks in those countries have
to use other instruments. Two such instruments are short-term deposits or
interventions on the foreign exchange market. These latter instruments have
been favoured by the National Bank of Romania (BNR) over the last several
years.
To see how this might work, assume that the BNR wanted to increase money supply. In this situation it will have to intervene in the foreign exchange market by buying foreign currencies and selling ROL. If for some reason the BNR believes that there is too much money in the market, it could “sterilise” some of it by paying commercial banks to deposit their money at the BNR.
However, for an economic analyst, sometimes it is very difficult to understand the intentions of a central bank. Especially if the central bank is learning about the new economic environment along with the other players in the economy. So, one can either believe the official message of the central bank or try to guess its intentions by looking at the bank’s actions. As far as I am concerned, I favour the second method, at least until a central bank has established policies that are consistent with stable prices.
But what do the BNR’s actions tell us? Several weeks back, it announced that its foreign reserves reached a new level of 13 billion euros. At the same time, it announced that its intervention rate fell in April to 7.96 per cent from 8.45 per cent previously. This is 13.25 per cent lower than in the same month a year ago. Furthermore, even though at prima facie the two pieces of information are not connected, they show the same thing: an increase in the money supply, a relaxation of monetary policy.
Against this background, the BNR made public its view that commercial banks allowed interest rates to fall way too much. And of course the BNR had nothing to do with it.
I beg too differ. Interest rates represent the price of money. Thus, if the money supply is increasing then you would expect interest rates to fall to re-establish the equilibrium in the money market. And by controlling the money supply, the BNR controls interest rates and thus it is responsible for their present level. Furthermore, as long as the BNR does not have a long-term view on its policy interest rate it is hard for commercial banks to guess the “right” level of interest rates according to the BNR.
This short analysis is supported by the data. One way to assess the level of liquidity in an economy is to compare the growth rate of money supply to the growth rate of nominal GDP. In 2003 nominal GDP and broad money supply grew by 25 per cent and 26 per cent respectively – the BNR was supplying enough money for the economy to grow. But in 2004, against the background of decreasing inflation, the BNR started to loosen its policy. At the end of the year, money supply growth was 40 per cent while nominal GDP growth was only 23 per cent. In other words, too much money was chasing too few goods and the way out is either through higher prices (to slow down demand) or faster economic growth and higher current account deficits (to satisfy higher demand).
At the same time faster growth of money supply is normal for an economy entering a low inflation environment, after years of high and variable prices, and as demand for ROL denominated assets is increasing. But it is very important how the liquidity is injected into the economy and of course how it is used. In general the demand for liquidity is satisfied by capital inflows. In Romania’s case this is supplemented by central bank interventions in the foreign exchange market.
One can see this by looking at growth rates for money supply and foreign reserves held by the BNR; these reserves grew by 57 per cent in 2004 and 20.4 per cent so far this year, which mirror money supply growth of 35 per cent in 2004 and 24.5 per cent in 2005 – the main reason for lower interest rates.
However, even though inflation is ultimately a monetary phenomenon, the higher money supply has not shown up in consumer prices – yet. One explanation is that the relationship between money and prices is not stable and it could take up to two years for money to affect prices.
But some of the effects of the looser monetary policy can be seen already. One is the growth of real estate prices which are increasing more rapidly than average income or even rents. Another is the ever-increasing current account deficit. And possibly the most dangerous for inflation, the proliferation of consumer credit with very high limits for the Romanian economy.
I think it is premature to believe that the war on inflation is already won. It takes several years of consistent and successfully applied monetary policy before inflation expectations are affected.
Finally, this is a period for everyone in the market, including the BNR, to learn about the new economic environment. And learning to live with short-term volatility, be it in exchange rates or any other market, is a major part of the process towards economic prosperity.
Florin Citu is Managing Director of BAC Romania, and investment bank.
