As a matter of fact, anticipating that inflation would decrease sharply following the last quarter of 2008, the central bank focused on alleviating the potentially harsh impact of the global financial crisis on the domestic economy. In this respect, it has delivered sizeable cuts in policy rates while providing liquidity support to facilitate the smooth operation of credit markets. The Monetary Policy Committee (PPK) continued to cut interest rates in the third quarter, bringing the cumulative rate cuts to 1,000 basis points since November 2008. Therefore, the Central Bank of Turkey lowered policy rates more than any other emerging market central bank since the intensification of the global crisis (see figures 1 and 2).
However, there are certain signs that the central bank will enter a more difficult era in the period ahead. There are increasing complaints from the banking sector that under current conditions, the yield on state bonds has declined significantly. They note that they cannot continue financing public sector deficits with the current yield profile. In that regard, they demand either significant reversals in the borrowing rates or that a certain amount of foreign resources be channeled into the Turkish economy. This, obviously, implies a credit-based International Monetary Fund (IMF) agreement.
In order to accurately capture the future course of monetary policy in Turkey after 2009, a set of factors should be correctly assessed. These are, mainly, the course of inflation, growth rates (indirectly unemployment) and public sector debt management.
To start with the first one, the Fourth Inflation Report of the Central Bank of Turkey in 2009 has been announced. According to the central bank forecasts, year-end inflation in 2009 would be between 5.0-6.0 percent with a 70 percent probability. The rate is forecasted to be between 3.9-6.9 percent in mid-2010, 4.9 percent in 2011 and 4.8 percent in the third quarter of the year 2012.
These inflation forecasts should be read together with growth targets. Before going on to growth targets in the medium term, let's look at the current situation briefly. An important observation on growth is that gross domestic product (GDP) displayed a significant upswing after four consecutive quarters of contraction, with domestic consumption demand rising markedly during the second quarter, mainly owing to the fiscal stimulus package. External demand, on the other hand, remained weak. The rise in consumption demand did not exert inflationary pressures as it was met by a run-down in inventories rather than an increase in production, therefore keeping resource utilization at low levels.
Moreover, high unemployment rates have continued to suppress domestic demand. Accordingly, aggregate demand conditions have continued to support disinflation. Data releases pertaining to the third quarter indicate that the expansionary impact of the fiscal measures has been receding. In this respect, consumption demand, after having increased markedly during the second quarter, has shifted to a weaker course. Although private investment is expected to increase slightly in the third quarter, low capacity utilization and high demand uncertainty is expected to hold back the recovery in capital expenditures. Accordingly, final domestic demand is expected to stay flat in the third quarter, after having increased significantly in the second quarter.
According to the fourth inflation report, overall economic activity is expected to recover gradually, with annual growth rates posting positive figures starting in the last quarter. Finally, growth targets for the period of 2010-2012 were announced in the medium-term program by the government. Average growth rate would be around 4 percent in this period. However, resource utilization is anticipated to remain below the long-term average for some time. In this context, our medium-term forecasts envisage that the output gap -- albeit closing faster than envisaged in the July report -- will remain disinflationary until mid-2012.
The third factor in determining the course of monetary policy is related to public sector fiscal balances. Data releases on inflation and economic activity since the third quarter of 2008 supported the central bank to continue the rate-cutting cycles. This process strengthened the impact of the policy decisions on expectations, in turn bringing government bond yields to historically low levels in a period when public sector borrowing requirements and rollover ratio rose dramatically due to emergency measures and rescue packages, as well as a radical decline in revenue collections.
As a result, government bond yields have further declined in the third quarter, along with the policy rate cuts and decreasing risk premiums. As noted in the central bank's 4th Inflation Report, monetary policy communication played a key role in bringing down longer-term rates, as the downward trend accelerated after providing a medium-term policy perspective in the 3rd Inflation Report.
Other than interest rate cuts, however, the central bank reduced the Turkish lira reserve requirements once again two weeks earlier in order to further alleviate the tightness in credit conditions and thus enhance the effectiveness of the policy rate cuts. Parallel to these measures, conditions in the credit market improved relatively, and recovery is expected to continue in the last quarter as well.
A final point to be noted is related to the central bank's basic assumptions around the factors affecting the future course of inflation. Although global economic growth is expected to follow a gradual path, commodity prices continued along a rising trend in the third quarter, with the growing perception that the recovery is on the way. In fact, oil prices were above the central bank's assumption of $60 per barrel in the third quarter. In this context, the previous assumption of average oil prices have been revised upwards from $60 per barrel to $70 for 2009, from $70 to $75 for 2010, and from $70 to $80 for 2011 and thereafter.
To sum up, it can be stated by considering the current set of available data that the future course of easy monetary policy has entered a period of uncertainty. In order to eradicate it, in addition to the Mid-Term Economic Program, other steps such as defining a fiscal rule against the coming elections and how the need for public financing is going to be recovered should also be taken.
