Summary

Developments in inflation and its determinants

The annual CPI inflation rate resumed its downward path in 2024 Q2, standing at 4.94 percent in June, i.e. 1.67 percentage points lower than in March. At the same time, due to a number of unanticipated favourable developments during Q2, especially in the utility (natural gas) price segment, in June headline inflation fell 1.1 percentage points below the forecast in the previous Inflation Report. Exogenous components accounted for about half of the progress seen in disinflation in Q2. Specifically, the auspicious conditions in wholesale markets for natural gas and electricity as well as a number of legislative changes allowed for a drop in these prices for household consumers. Moreover, although oil prices fluctuated in both directions during the months of Q2, the annual growth rate of fuel prices was lower at the end of the period than in March. In turn, the annual core inflation rate declined at a pace close to that seen in 2024 Q1, i.e. by 1.4 percentage points, with all three groups of the index contributing to a relatively similar extent to disinflation. The average annual inflation rate, a measure with inherently higher persistence, remained on a downward trend in Q2, with the indicator calculated based on the national methodology (CPI) falling to 7.2 percent and the indicator calculated in accordance with the harmonised structure (HICP) going down to 7.3 percent. Thus, during Q2 the correction amounted to 1.3 percentage points for the first indicator and to 1 percentage point for the second one. The differential against the EU average came in at 3.7 percentage points and hence remained close to that posted at the end of the previous quarter, reflecting further a slower disinflation for Romania.

The annual adjusted CORE2 inflation rate followed a steady downward path in 2024 H1, yet the pace of disinflation slowed down. In June, the annual adjusted CORE2 inflation rate declined to 5.7 percent, i.e. 0.2 percentage points below the forecast in the previous Inflation Report. In Q2, all three groups of the indicator had relatively balanced contributions to disinflation. However, the levels reported by the three sub-components remained strongly divergent. Food items made the strongest progress, their annual price dynamics falling to 2.1 percent. In contrast, although disinflation sped up in the non-food and services segments compared to the previous quarters, the annual growth rates of these prices are further elevated (8.6 percent and 8 percent respectively in June). The developments reflect the relatively favourable context, given the milder inflationary influences from input costs of materials and import prices – both having a relevant impact on non-food prices –, but also the softer demand for market services. Favourable contributions came also from economic agents’ short-term inflation expectations and financial analysts’ medium-term inflation expectations. Conversely, factors such as the pressure from wage costs and excess demand continue to hinder the disinflationary process of these components, putting core inflation on a slowly downward trajectory.

The annual dynamics of unit labour costs economy-wide continued to accelerate in 2024 Q1 to reach 21.6 percent (compared to 15.4 percent in the previous quarter), as the slowdown in economic activity was not accompanied by labour force or compensation adjustments. Thus, labour productivity shed 3.3 percent in annual terms, while the pace of increase of compensation per employee, albeit slower, remained fast (17.6 percent, -0.9 percentage points from 2023 Q4), further generating inflationary pressures. In industry, the annual growth rate of unit wage costs declined to 14.4 percent in April-May, from 18.1 percent in the previous two quarters, amid a low output volume, correlated with weak external demand. The moderation in the rate of increase of unit wage costs was almost across the board, with the following industries still recording larger fluctuations (above 20 percent): beverages, crude oil processing, manufacture of rubber and plastic products and manufacture of electronic products.

Monetary policy since the release of the previous Inflation Report

In its meeting of 13 May 2024, the NBR Board decided to keep the monetary policy rate at 7.00 percent per annum. The interest rates on standing facilities were also left unchanged at 6.00 percent per annum (the deposit facility rate) and at 8.00 percent per annum (the lending facility rate). In March the annual inflation rate returned to the level seen at end-2023 (6.61 percent), as the increases in the dynamics of electricity, fuel and tobacco product prices in 2024 Q1 overall were counterbalanced, in terms of impact, by the deceleration of core inflation and the decline in the dynamics of VFE prices. Specifically, the annual adjusted CORE2 inflation rate continued to fall in the first three months of 2024, albeit at a slower pace than in the previous two quarters. Behind the deceleration stood, during this period as well, disinflationary base effects, corrections of agri-food commodity prices and the measure to cap the mark-ups on basic food products, alongside the decreasing dynamics of import prices. The impact of these factors was mitigated by the effects of the fiscal measures implemented at the beginning of this year and by higher short-term inflation expectations. To these added the influences exerted by wage cost increases that occurred towards the end of last year, which were passed through, at least in part, into the prices of some services and non-food items, inter alia amid the rebound in private consumption.

Significant uncertainties and risks to the inflation outlook stemmed from the fiscal and income policy stance, given on one hand the budget execution in the first three months of the year, the public sector wage dynamics and the full impact of the new law on pensions, and on the other hand the additional fiscal and budgetary measures that could be implemented in the future to carry on budget consolidation, inter alia amid the excessive deficit procedure and the conditionalities attached to other agreements signed with the EC. Labour market conditions and wage growth in the economy were also a source of sizeable uncertainties and risks. Moreover, uncertainties and risks to the outlook for economic activity, implicitly the medium-term inflation path, continued to arise from the war in Ukraine and the Middle East conflict, as well as from the economic performance in Europe, especially in Germany. Furthermore, the absorption of EU funds, especially those under the Next Generation EU programme, is conditional on fulfilling strict milestones and targets. However, this is essential for carrying out the necessary structural reforms, energy transition included, as well as for counterbalancing, at least in part, the contractionary impact exerted by geopolitical conflicts. The ECB’s and the Fed’s prospective monetary policy stances, as well as the conduct of central banks in the region continued to be also relevant.

Subsequently, the annual inflation rate saw a faster decline in the first two months of 2024 Q2, falling to 5.12 percent in May, below the forecast, mainly as a result of the notable drop in energy prices, especially natural gas prices, following the legislative changes implemented as of April, as well as amid the further deceleration in the growth rate of food prices. At the same time, the annual adjusted CORE2 inflation rate continued to decrease gradually, in line with forecasts, down to 6.3 percent in May from 7.1 percent in March 2024. Behind the deceleration stood, during this period as well, disinflationary base effects and corrections of agri-food commodity prices. Additional influences stemmed from the decreasing dynamics of import prices and from short-term inflation expectations re-embarking on a slight downtrend. A moderate opposite impact had the new hikes in unit labour costs recorded in the first months of 2024, which were passed through, at least in part, into the prices of some goods and services, inter alia amid a robust consumer demand that increased strongly in April. In turn, economic activity expanded in 2024 Q1 to a lower extent than anticipated, after its contraction in 2023 Q4, which made it likely for excess aggregate demand to have further narrowed over this period, contrary to expectations. Moreover, annual GDP growth contracted markedly in 2024 Q1 to 0.1 percent from 3 percent in the previous three months. The decline was driven this time round mainly by gross fixed capital formation, whose annual dynamics plummeted from the very high two-digit level seen in 2023 Q4, whereas household consumption continued to witness a faster annual rise. In turn, net exports exerted a larger contractionary influence in 2024 Q1, against the backdrop of a slight pick-up in the differential between the positive dynamics of the import volume of goods and services and the change in the export volume, which remained in negative territory. However, the annual growth rate of the trade deficit remained unchanged, while that of the current account decreased considerably from the previous quarter, given, inter alia, the strongly faster increase in the secondary income surplus during this period, mainly on account of inflows of EU funds to the current account.

At the time of the NBR Board meeting of 5 July 2024, the latest assessments showed that the annual inflation rate would decline further over the following months, on a significantly lower path than that shown in the May 2024 medium-term forecast, primarily due to base effects and legislative changes in the energy field, as well as amid the deceleration in import price growth and the gradual downward adjustment of short-term inflation expectations. The previously identified risk and uncertainty factors remained relevant.

Considering the assessments and data available at that moment and the prospects for the annual inflation rate to decline further over the following months, on a significantly lower path than previously anticipated, but also in light of the still elevated uncertainty, the NBR Board decided to cut the monetary policy rate to 6.75 percent per annum from 7.00 percent per annum starting 8 July 2024. Moreover, it decided to lower the lending (Lombard) facility rate to 7.75 percent per annum from 8.00 percent per annum and the deposit facility rate to 5.75 percent per annum from 6.00 percent per annum. Furthermore, the NBR Board decided to keep the existing levels of minimum reserve requirement ratios on both leu- and foreign currency-denominated liabilities of credit institutions.

Inflation outlook

The global economy has continued its recovery after multiple overlapping supply-side shocks. Over the recent quarters, while global economic growth lost momentum, it showed resilience. At the same time, corrections in inflation rates were recorded, illustrating the remarkable progress made against the values reached at the height of the crisis. Inflation continued to be a matter of concern in the euro area, with supply-side shocks and stubbornly-high services price inflation still marking its path. In the region, economic activity showed signs of recovery, yet unevenly distributed across sectors and rather moderate, given the further tight financial conditions and numerous geopolitical uncertainties.

This raises the prospect of a relatively gradual economic recovery in the years ahead, influenced inter alia by persistent inflation and sluggish labour market adjustments. Moreover, global geo-economic fragmentation trends, as well as the ongoing electoral “super-cycle” in both Europe and important geographical regions, with many successive election rounds scheduled for this year, also fuel the persistently high economic uncertainty.

In Central and East European economies, Romania included, inflation dynamics were influenced by both global factors and local policies. In particular, Romania faces a fiscal policy that calls for adjustments in order to attain a sustainable budget deficit. Given that the country continues to be subject to the excessive deficit procedure, taking adjustment measures is essential both to fend off more severe macroeconomic disequilibria and to secure fiscal sustainability over the medium and long term.

Thus, the global and regional economic prospects remain fragile, sometimes divergent, and riddled with significant risks. Particularly for the emerging economies, risks are associated with a potential volatility of capital flows, inter alia in connection with the calibration of monetary policies pursued by the world’s major central banks. For all these reasons, a cautious approach to managing economic policies is of the essence to ensure a sustainable economic recovery and to meet inflation targets in the medium term.

In the May 2024 Inflation Report, projections suggested that the weaker domestic economic activity in 2023 Q4 was only short-lived. This assessment was confirmed by the subsequently published NIS data, which indicated a return of GDP dynamics into positive territory in Q1, i.e. 0.7 percent. Nonetheless, the key components of domestic demand displayed softer-than-expected developments, with household consumption almost stalling against the previous quarter and gross fixed capital formation (GFCF) even decreasing in quarter-on-quarter comparison. Moreover, the faster recovery of economic activity in euro area trading partners earlier this year was accompanied by a mild decrease in the negative contribution of net exports to economic growth in Romania. In correlation with these developments, the positive output gap was stuck in 2024 Q1 to the downward path seen throughout the previous year, before reaching over the next two quarters values similar to those projected in the prior Report. Given that Romania continued to report excessive government deficits and, until the completion of the analysis, the authorities did not put forward a package of fiscal consolidation measures, excess aggregate demand is foreseen to persist throughout the eight-quarter projection.

In 2024 Q1, GFCF posted a quarter-on-quarter contraction, owing chiefly to the weaker-than-anticipated performance of construction. A reason behind the developments in the GFCF was probably that EU funds under the 2014-2020 financial framework were used up, as they reached an absorption rate of over 90 percent at end-2023. The evolution was also reflected in the dynamics of public investment, financed in the first part of the year mainly from own and borrowed sources and to a much lesser extent from EU funds. Furthermore, even though the Romanian authorities collected approximately EUR 9.4 billion from NRRP funds since the beginning of the programme, their actual use in the financing of investment programmes was rather modest at an estimated 20 percent of the total figure. Conversely, foreign direct investment remained a major funding source, with noticeably higher inflows than those of last year, yet debt instruments are favoured over equity in their composition, according to the latest data.

Despite posting a quasi-stagnation in 2024 Q1, private consumption is foreseen to return to robust rates of increase starting Q2 and, for the year as a whole, to become again the main driver of economic growth. In this vein, the groundwork for restoring households’ purchasing power was laid as early as last year and is set to strengthen in the future. Specifically, the ongoing disinflation, the effects induced by a still robust labour market, the sizeable contribution of public sector wage policies and strong rises in social transfers foreseen for 2024 H2 (e.g. the new pension law) are expected to underpin a steady expansion in domestic demand and private consumption. Even though the anticipated increase in real income will render more flexibility to households’ consumption expenditure, helping boost economic activity, looking ahead, it is particularly important to rebalance as fast as possible wage growth, which is already extremely strong, with productivity dynamics. Over the medium term, this process is essential not only to support the gradual return of inflation rate towards the target, but also to avoid further external competitiveness losses of Romania’s economy.

The current account deficit-to-GDP ratio narrowed by approximately 2.2 percentage points in 2023 from the year before, standing at 7 percent. Subsequently, statistical data showed this year a reversal of the downtrend of the indicator, with less favourable contributions associated with most sub-components, with secondary income being the only notable exception. Looking at the dynamics, the recent developments in the current account deficit may partly be associated with seasonal effects affecting some components, yet structural causes prevailed, according to quantitative assessments. Specifically, the tourism-travel component, influenced chiefly by seasonal factors, saw a widening of its deficit this year as well, and, in turn, of its negative contribution to the current account deficit. Conversely, other components, such as net payments of portfolio investment income, accounting for approximately 15 percent of the current account deficit according to data for May, reflect a higher structural requirement for government deficit financing and public debt refinancing. Against this background, further larger adjustments to the current account deficit are strictly conditional on those to the budget deficit and, in particular, on bringing the latter back in line with the targets set in the excessive deficit procedure as quickly as possible. Of course, notable headway in the correction of the external deficit also hinges on a stronger recovery in the economic activity of EU trading partners, yet the progress made so far is still rather slow.

According to the updated baseline scenario, after standing at 4.94 percent in June 2024, the annual CPI inflation rate will follow a mostly downward path, with two dominant features. First, the pace of disinflation is projected to slow down in 2024, and particularly in 2025 and 2026. Second, the trajectory of the annual CPI inflation rate will be marked by some fluctuations, mainly as a result of base effects – e.g. the projection shows a low of 2.9 percent at the end of 2025 Q1 due to the hike in some indirect taxes (VAT and excise duties) in January 2024 dropping out of the annual inflation rate. Once base effects have faded out, the dynamics of the indicator stabilise in the upper part of the variation band of the target starting 2025 Q3, without exceeding, however, 3.5 percent. Specifically, the annual CPI inflation rate is projected to reach 4 percent at end‑2024, 3.4 percent at end‑2025 and 3.2 percent at the forecast horizon, i.e. June 2026. Partly due to the recent developments implying faster disinflation of most of the basket sub-components, the new projected path of the annual CPI inflation rate is lower than in the previous Report, down 0.9 percentage points in December 2024 and by 0.2 percentage points in December 2025.

Over the entire projection interval, the adjusted CORE2 index will remain the major determinant of the decline in the annual headline inflation rate. At the same time, amid the recent legislative changes that enabled the cut in utility prices, especially natural gas prices, the contribution of exogenous components of the CPI basket to headline inflation will decrease slightly at the end of this year from end-2023 and will then stay at a relatively close level, i.e. 1.1-1.2 percentage points, also towards the end of the projection horizon. The annual adjusted CORE 2 inflation rate will follow a steadily downward course, driven by softer inflation expectations and abating pressures from import prices. However, core inflation will exceed headline inflation over most of the projection interval, given the still strong unit labour cost pressures fuelled by both recent and anticipated pay rises. Annual wage dynamics will stay relatively high, yet while in the private sector a deceleration is foreseeable during this year, in the public sector they will step up from last year, given the wage increases already enacted and partly already granted. For December 2024, the annual core inflation rate was revised downwards to 4.6 percent (-0.7 percentage points from the previous Report), amid visible progress especially in the non-food component. This was recently accompanied by a good performance also in the case of processed food and market services, which is anticipated to continue, albeit at a relatively slow pace for the latter. For this reason, in 2025 the differences in the indicator against the previous projection are diminishing markedly, while they benefit primarily from downward revisions in inflation expectations and, in part, in import prices. Conversely, the output gap will closely reflect the fiscal policy stance and the projected developments in the budget deficit. Hence, the annual core inflation rate is seen dropping to 3.5 percent in December 2025 and thereafter to 3.4 percent in March and June of 2026.

The NBR’s recent monetary policy stance aimed to bring the annual inflation rate back in line with the 2.5 percent ±1 percentage point flat target on a lasting basis, inter alia via the anchoring of inflation expectations over the medium term, in a manner conducive to achieving sustainable economic growth.

Since the past Inflation Report, a number of risk factors from those already identified have materialised, in particular those associated with new pay rises in the public sector (e.g. higher wages granted to public administration staff). Moreover, geopolitical tensions in the Middle East linger on, yet their direct economic effects are rather contained so far. Even in these conditions, the assessed balance of risks suggests possible upside deviations of inflation from its path in the baseline scenario, particularly in the case of new adverse supply-side shocks materialising.

The labour market features, reflected in the still relatively high tightness, continue to pose relevant risks to the inflation projection. Specifically, the swift wage dynamics economy-wide, induced by hikes in the minimum wage, fast pay rises in the public sector, but also by the strongly competitive labour markets, could trigger persistent inflationary pressure. In fact, high increases in unit labour costs have been recorded in the recent quarters and are also expected in the future. Against this background, wage increases significantly exceeding productivity growth economy-wide could be accommodated by firms only insofar as these costs would be, at least partially, passed on to consumers. In Romania’s economy, such a business approach could also be spurred by the persistent excess aggregate demand, which may further fuel strong inflationary pressures even amid the stabilisation of other inflation determinants, such as energy or food prices.

In this vein, the macroeconomic policy mix should be aimed at effective control of aggregate demand and, in particular, of the consumer demand component. In the model for analysis and medium-term forecasting, a synthetic indicator quantifying the excess pressures of aggregate demand is the output gap. A credible fiscal consolidation is needed in order to correct the excessive budget deficit and hence to calibrate a countercyclical fiscal policy that narrows the positive output gap. This implies structural reforms to enhance government revenues and, at the same time, exert stricter control over expenditures. By the time the baseline scenario of the projection was completed, the authorities had not announced either the dosage or the nature of the fiscal measures that could be adopted as of 2025: changes in direct or indirect taxes, measures for rationalising public spending, measures to boost revenue collection, etc. Moreover, according to information available in the public space, the possibility emerged, without being however firmly confirmed, that Romania would negotiate a fiscal adjustment plan extended over a longer period, up to seven years. Ceteris paribus, such a plan would directly imply that the average annual fiscal consolidation effort would diminish accordingly. Strictly for this year, the busy electoral calendar does not rule out the risk of a fiscal slippage especially should new expansionary measures imply persistent increases in budget spending. In such a case, the starting point for the authorities’ multiannual endeavour to correct excessive budget deficits could be higher, implying that the entire future path of budget deficits would shift upwards as against the working assumptions in the baseline scenario (based on information that is certain at the time of completing the projection). Looking ahead, regardless of the source of excessive budget deficits, either higher government consumption expenditures, larger social transfers or more sizeable capital expenditures, the budget deficit correction is called for both in view of Romania’s commitments to the European Commission and for ensuring a balanced mix between the fiscal policy stance and the monetary policy stance over the medium term.

Although Romania and, more generally, Central and East European countries currently undergo an economic recovery, certain external factors, such as global inflationary shocks, tighter financial conditions or volatile energy prices, also due to geopolitical tensions, are significant risk sources. Hence, geopolitical risks – the war in Ukraine and, more recently, Middle East tensions –, which tend to become permanent, pose challenges to the smooth functioning of trade and investment flows. Any escalation of these tensions may weigh on trade routes, supply chains and already in place investment models, triggering significant disruptions to exports and imports and thus potentially generating stagflation risks (surging prices and, implicitly, higher inflation, together with stalling or even declining economic activity).

Monetary policy decision

In view of the significant improvement in the near-term inflation outlook versus the previous projection, but also amid the still elevated uncertainty surrounding forecasts over the longer time horizon, the NBR Board decided in its meeting of 7 August 2024 to cut the monetary policy rate by 0.25 percentage points to 6.50 percent. Moreover, it decided to lower by 0.25 percentage points the lending (Lombard) facility rate to 7.50 percent and the deposit facility rate to 5.50 percent. Furthermore, the NBR Board decided to keep the existing levels of minimum reserve requirement ratios on both leu- and foreign currency-denominated liabilities of credit institutions.