Responding to Criticism of Monetary Policy in Romania in the Decade Surrounding the 2008 Financial Crisis (2004-2013)

We use the experience of Romania between 2008 and 2013 to show that (i) once faced with huge capital inflows and persistent inflationary expectations (as it was the case between 2004 and 2008), a country may lose the interest rate as its main monetary policy instrument and (ii) an interest rate cut might not be a way to alleviate a recession induced by a capital flows sudden stop (as happened in 2009) if the private sector is highly indebted in foreign currency. In the first case, the loss of policy instrument appears because high inflation expectations require an increase in the interest rate, whereas high capital inflows widen the inflationary output gap and tend to appreciate the currency, requiring a cut in the interest rate. In the second case, a large policy rate cut needed to stimulate growth would result in a high depreciation, with the negative effects on the balance sheets of households, companies and banks, potentially outpacing the benefits of larger exports, thus depressing recession. We use the results produced by the National Bank of Romania’s Macroeconomic Modelling and Forecasting Department to show that: a) the claim that a higher increase in the monetary policy rate may have led to a lower inflation before the 2008 crisis is not grounded; b) an abrupt cut in interest rate would have depressed the recession of 2009.