The good news is the taming of inflation as across-the-board disinflation (prices rising more slowly) not deflation (prices falling), as shown in chart 1. The bad news is the painful way inflation is tamed through a severe recession with sharply falling output and rising unemployment. In 2008's last quarter, the Turkish real gross domestic product (GDP) contracted at a year-on-year rate of 6.2 percent, pushing the non-agricultural unemployment rate close to 16 percent. The real GDP, expected by the central bank to contract in the double digits in this year's first quarter, is projected by the International Monetary Fund (IMF) to contract at 5.1 percent in 2009. Disinflation is the silver lining in the cloud of economic contraction. Unlike several advanced economies fearing deflation that can further worsen their economic and financial plights, Turkey, like many emerging economies, is reaping one of the few benefits of the global crisis through substantial disinflation. Ironically, until less than a year ago almost all emerging economies practicing inflation targeting, including Turkey, had been overshooting their targets. Now they are concerned about undershooting them.
The central bank's inflation report also revises downward, due to sharper-than-expected economic contraction at home and abroad, its inflation forecasts for 2009-2011 from those in its January inflation report. It now forecasts, based on its baseline scenario, that, with 70 percent probability (confidence interval), inflation will fall between 4.8 percent and 7.2 percent, with a mid-point of 6 percent, at the end of 2009, and between 3.5 percent and 7.1 percent, with a mid-point of 5.3 percent, at the end of 2010. The mid-point forecasts for 2009 and 2010 are lower than the IMF's forecasts of 6.9 percent and 6.8 percent for 2009 and 2010. Its forecast for 2011 year-end inflation is 4.9 percent. What is remarkable is that its mid-point forecasts for 2009-2011 are all below its inflation targets shown in chart 2. Based on its alternative, more pessimistic scenario, assuming that the global crisis will continue to worsen in 2009 and that economic recovery will not begin until 2011, the inflation targets could be undershot even more despite further measured interest rate cuts throughout 2009.
The central bank emphasizes that fiscal policy is the other major factor that can affect the inflation outlook and its monetary policy. It warns against the widening budget deficit due to the Justice and Development Party (AK Party) government's expansionary fiscal policy, with tax revenues declining but expenditures rising in the midst of worsening recession. The financing requirement of the widening budget deficit could weaken the positive effect of the looser monetary policy on economic activity. It urges the government to devise a credible medium-term plan to impose fiscal discipline and ensure debt sustainability as well as commit to structural reforms. It stresses the importance of reviving the EU accession process and implementing the structural reforms specified in the Pre-Accession Economic Program.
The central bank has preemptively and aggressively cut its overnight interest rates six times in a row by a cumulative 7 percent since last November to fight the deepening recession. This was a record in rate cutting among emerging economies that are practicing inflation targeting. With its most recent rate cut of 0.75 percent on April 16, which brought its overnight borrowing rate down to 9.75 percent, it wished not only to continue fighting the deepening recession by easing credit, but also to lower the probability of significantly undershooting its year-end inflation target. This is quite a change from its problem of overshooting its inflation targets between 2006 and 2008 as shown in chart 2.
Although, in the midst of an excruciating recession, inflation is not the most critical problem. As Turkey experiences much-welcome disinflation, the central bank is commendably sticking to inflation targeting with more realistic targets than those seen in the 2006-2008 period. Inflation will surely return as a major concern after economic recovery begins sooner or later. The current disinflation environment provides an excellent chance for the central bank to hone its targeting skills as inflationary expectations diminish significantly. The long-awaited IMF stand-by arrangement, once it materializes after almost a year of protracted negotiations, will also help by strengthening the AK Party government's fiscal discipline, which is essential for the success of inflation targeting. The most important asset of a central bank is its credibility, which can be very hard to regain once lost. The central bank, under attack by those who either have not understood or benefited from the economy-wide costs of high and unstable inflation, has faced great difficulty in defending its newly gained independence to achieve and maintain price stability through inflation targeting. Let's hope that the central bank will achieve enduring success in taming inflation, which has been the country's scourge for so long.
