Romania's central bank held interest rates at 6.25 percent on Wednesday, as expected, halting its easing cycle after a government plan to raise value added tax added to uncertainty about the economy.
Concerns are mounting about the speed of recovery in emerging Europe and governments like Romania's are struggling to convince investors they can keep fiscal consolidation plans on track and prevent a debt crisis in the euro zone from spreading.
Poland is also expected to keep interest rates on hold later on Wednesday, given inflation is expected to remain below the central bank's target and the economy, although improving, may still be fragile.
Romania's leu EURRON= has hit all-time lows against the euro this week after the government decided to hike VAT to plug a funding gap and ensure resumption of a 20 billion euro, International Monetary Fund-led bailout package.
The decision is not really surprising, given all that has happened, said Raffella Tenconi, chief economist with brokerage Wood & Co in Prague.
It would be interesting to see in their detailed statement if they're turning modestly hawkish as the leu is weakening. There is very little scope for monetary policy easing.
A cut in public wages, coupled with higher VAT, will help keep Romania's budget deficit under control and will probably ensure the IMF agrees to release the next tranche of economic aid when it meets on Friday, reassuring jittery markets.
But the austerity measures have worried investors as the VAT hike by five percentage points to 24 percent increases inflation risks and, coupled with a 25 percent cut in public sector wages, will likely dampen consumption and economic growth.
This decision shows a careful positioning of the central bank given major uncertainties on the fiscal side related to the impact of recent moves including the value-added tax increase, said Ionut Dumitru, chief economist with Raiffeisen Bank in Bucharest.
Our expectation is that inflation can now be heading towards 8-8.5 percent at the end of the year, also due to hikes in (household) heating prices and leu depreciation.
The leu was almost unchanged after the interest rate decision and was trading 0.5 percent higher on the day at 4.365 per euro by 1010 GMT.
Finance Minister Sebastian Vladescu said on Tuesday he expects the economy to contract more this year than previously forecast, predicting a drop of between 1 and 2 percent in gross domestic product. Borrowing costs are currently at a record low following 400 basis points worth of easing since the start of last year. Most analysts had expected a further cut of 25 basis points before the VAT hike was announced last weekend.
The central bank will release a more detailed statement later on Wednesday. (Additional reporting by Ioana Patran and Sam Cage; editing by Patrick Graham)