Inflation targeting in Turkey

Inflation targeting is defined as “a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal. Among other important features of inflation targeting are vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and, in many cases, mechanisms that strengthen the central bank’s accountability for attaining those objectives.” (Ben Bernanke et al, “Inflation Targeting: Lessons from the International Experience,” Princeton University Press, 1999. p. 4) Inflation targeting has three major benefits: 1) it improves transparency, providing for better communication and helping economic agents understand the central bank’s objectives; 2) its forward-looking nature draws attention to future inflation; and 3) it makes the central bank accountable. Inflation targeting has proved to be a durable monetary strategy compared to others such as targeting monetary aggregates or using the exchange rate as a nominal anchor. Since 1990, when New Zealand became the first country to adopt inflation targeting, 27 countries (about half of them developing countries such as Turkey), have become “inflation targeters.” Only two of them abandoned the method, but not because of economic duress. They were Finland and Spain, which joined the European Monetary Union for which the European Central Bank keeps an inflation target as part of its monetary strategy.

Chronic inflation had been steadily multiplying in Turkey since the late 1960s, reaching triple digits in the early 1980s and the mid-1990s. Inflation fell sharply during 2002-2003 to about 10 percent from an average annual rate of about 70 percent in the 1990s. Since then, however, it has stabilized at around 10 percent. The central bank began to acquire operational as well as de jure independence from government political pressures, a primary prerequisite for inflation targeting, after 2001 as part of its International Monetary Fund (IMF)-sponsored and supervised economic stabilization program. The new Turkish Central Bank Law, enacted in 2001, also stated explicitly that achieving and maintaining price stability is the primary objective of the central bank, another primary prerequisite for inflation targeting, under transparency and accountability. After successfully implementing implicit inflation targeting during 2002-2005 as specified in the letter of intent submitted to the IMF in November 2001, the central bank adopted explicit, full-fledged inflation targeting in 2006.

The central bank defines its inflation target as the year-end rate of inflation calculated by the annual percentage change of the CPI in the upcoming period. It sets its target horizon as the next three-year period, in harmony with the government three-year budget practice. The bank has set a symmetrical uncertainty band of 2 percent in both directions around the point target. Due to this relatively wide uncertainty band, some critics of the central bank’s inflation targeting have labeled this “inflation targeting lite.” If inflation occurs outside this band, the central bank submits a report to the government, shared with the public, explaining its reasons for the divergence as well as the measures it will take to get back to the target. The TCMB will change its inflation target if it expects sharp and long-term deviations from the target and the medium targets become unrealistic because of factors that monetary policy cannot control. With temporary shocks, however, the TCMB revises only its inflation forecasts instead of its inflation targets. Therefore economic agents use the inflation forecasts, published in its quarterly inflation reports, for the short term and the inflation targets for the medium term. The last inflation report, issued at the end of last month (www.tcmb.gov.tr/research/parapol/enf-temmuz2007.php), forecasts inflation will be between 5.1 and 6.9 percent (midpoint 6.0) at the end of 2007, and between 1.5 and 4.9 percent (mid-point 3.2) at the end of 2008. The central bank states that, under Turkey’s floating foreign exchange (FX) regime, another primary prerequisite for inflation targeting, the FX rate is neither a target nor a policy instrument. It defines as its only target the inflation rate and as its major policy instrument short-term interest rates.

The opponents of inflation targeting have primarily been those who believe (wrongly) that inflation targeting will result in a rate of inflation that is too low and will adversely affect the rate of economic growth. Actually Turkey has experienced outstanding economic growth coupled with rapid disinflation since 2002. There are also opponents of inflation targeting who are against the floating FX regime itself, arguing that it has resulted in an overvalued Turkish lira, hurting Turkish exports and widening the current account deficit. The recent remarkable performance of Turkish exports indicates that the FX rate has not been a major obstacle to Turkey’s international competitiveness.

The Turkish Central bank missed its first year’s ambitious CPI inflation target of 5 percent in 2006, during which the CPI rose by 9.65 percent. It blamed this on supply-side shocks. As evidence, it noted that the inflationary expectations at the end of 2006 for the next 24 months stood at 5.5 percent. It resisted pressures to increase its inflation targets. The central bank’s annual inflation target for the period 2007-2009 is 4 percent. Why is the target set at 4 percent? According to the bank, “taking into account the structural transformation of the economy, the transition from chronic high inflation to low inflation and the process of convergence to the developed countries, a target of around 4 percent is considered appropriate for the medium-term. … As the structural transformation and convergence process is completed in time, it will be possible to target lower inflation rates.” (”Monetary and Exchange Rate Policy for 2007,” Central Bank of the Republic of Turkey, Dec. 13, 2006). The central bank itself expects to miss this target for 2007 despite the recent deceleration in inflation noted earlier.

Compared to the nominal FX rate-anchored stabilization program with an ill-considered hybrid currency board arrangement which Turkey tried unsuccessfully prior to 2001, the inflation targeting program has been quite successful since 2002, despite the central bank’s missing its target badly in its first year of formal practice during 2006 and almost certain to miss it again to a lesser extent this year. I commend the bank is for its sustained efforts to tame inflation and establish inflation targeting in Turkey.