The inflation target for end-2009, set at 7.5 percent, will also undershoot. Under normal conditions, this could be construed as more of a success than a failure for the central bank, as undershooting would be preferable to overshooting, but the faster-than-targeted disinflation has occurred in the midst of the worst recession in the last 60 years, which followed the worst financial crisis since the 1930s. Before the onset of the global financial crisis, the annual inflation rate, which had been climbing between July 2007 and July 2008, forcing the central bank to miss its targets, was almost 12 percent.
Turkey’s remarkable disinflation has occurred during an extraordinary interest rate cutting cycle. The central bank has aggressively cut its overnight borrowing policy rate by 1000 basis points, from 16.75 percent to 6.75 percent since November 2008, more than any other emerging market country central bank, in order to mitigate the damages of the extremely deep and painful economic downturn. The lowering of short-term interest rates, along with falling risk premiums, has helped in pushing not only private short-term rates, such as consumer loan rates, but also long-term interest rates, especially government domestic bond yields, to historically low levels. The yield curve has continued to flatten as the difference between the six-month and four-year market interest rates narrowed significantly since late July. But since early October, there has been sustained upward pressure on government domestic bond market yields as sales by both residents and non-residents, concerned about the Treasury’s stepped up borrowing, have accelerated their sales.
Besides cutting its policy rates, the central bank decreased the Turkish lira reserve requirements to reinforce the effect of rate cuts on relieving the tightness in credit markets. The implied short-term real interest rate, now at less than 1.5 percent, is one of the lowest among emerging market economies. The central bank’s aggressive rate cuts have not adversely affected either the Turkish lira’s foreign exchange (FX) rates or the central bank’s FX reserves because of the lower interest rates everywhere else and the abundant global liquidity provided by developed-country central banks. After its last meeting on Oct. 15, the central bank’s Monetary Policy Committee (PPK) announced that, based on the partial labor and credit market improvements, it might consider slowing down its pace of rate cuts, depending on developments in the Turkish and global economies. It underlined, however, the need for an easing bias in monetary policy for a long period due to the fragile and tentative recoveries in both the domestic and global economies. In this year’s fourth inflation report, released last Tuesday, the central bank reaffirmed this bias. The report expects the Turkish economy’s recovery to be gradual, with the real gross domestic product (GDP) beginning to grow in the last quarter. Its medium-term forecast predicts that the output gap, the percentage difference between the potential and the actual real GDP, although narrowing faster than foreseen in its third inflation report in July, will stay disinflationary until mid-2012, even when policy rates remain low. The output gap is expected to fall from close to 8 percent at end-2009 to about 3 percent at end-2010 and largely disappear by mid-2012.
The central bank’s economic growth and inflation forecasts assume not only that the Justice and Development Party (AK Party) government will fully implement its Medium Term Program (MTP), supported with structural reforms for tougher fiscal discipline, but also that world interest rates will remain low for an extended period. The central bank emphasizes that both its forecasts and its monetary policy stance depend on new data on important domestic and global developments. The central bank’s inflation forecasts, assuming limited further policy interest rate cuts during the rest of this year and no changes in 2010, envisage, with 70 percent probability, inflation between 5.0 percent and 6.0 percent, with a mid-point of 5.5 percent, at end-2009; and between 3.9 percent and 6.9 percent, with a mid-point of 5.4 percent, at end-2010. The central bank expects inflation to drop to 4.9 percent at end-2011 and to 4.8 percent by 2012’s third quarter. In its July inflation report, the central bank predicted that with 70 percent probability, inflation would be between 4.9 percent and 6.9 percent, with a midpoint of 5.9 percent, at end-2009; and between 3.7 percent and 6.9 percent, with a mid-point of 5.3 percent, at end-2010. Its forecasts for end-2011 and mid-2012 were the same.
As I noted in my last column, budget deficit/GDP and public debt/GDP ratios have been rising rapidly in many countries due to the fiscal stimulus packages aimed at fighting the global economic crisis. The central bank recognizes this trend and its risks in terms of worsening inflationary expectations and increasing global interest rates if the exit strategies to ensure fiscal discipline are delayed. Its forecasts of much welcome further disinflation in a country which had suffered from double-digit inflation for many decades -- with the annual inflation rate averaging 72 percent from 1995 to 2001 -- could be undermined by the failure of the MTP to ensure fiscal discipline and the central bank’s reluctance to tighten monetary policy in reaction to that failure, notwithstanding its repeated promises to do so. The central bank’s reluctance could stem from the AK Party’s often expressed frustration with the central bank’s still controversial independence. This frustration could intensify if the economy’s recovery lags as the 2011 parliamentary elections approach. The AK Party’s hesitance in concluding a new stand-by arrangement with the International Monetary Fund (IMF) is also bound to exacerbate the dilemma facing the central bank.
There is one more factor that would complicate life for the central bank in its attempt to cut rates further or even to keep them steady as Turkey tries to attract foreign capital to finance its chronic current account deficit caused by its deficiency in savings. Several central banks, besides those that have already begun to unwind their emergency monetary stimulus measures while keeping rates steady, have not only stopped cutting rates but have started to raise them. Israel began the trend in late August, followed by Australia, the first G-20 country to do so, early this month. Last week Norway became the first European country to raise rates. Others such as Brazil, India, South Korea and Taiwan are expected to hike their rates soon. The Central Bank of Turkey has a tough row to hoe in the months and years ahead.
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