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Summary: While the markets seem to have been satisfied with the Fed’s decisions, the developing countries have once again started to feel the pressure of currency appreciation and the rapid capital inflows. In due course, Turkey continues to proceed with their plan to struggle amidst the new global economic backdrop and tries to intervene via new and old tools, where the constraint is the inflation outlook.

The long awaited decision by the FOMC has finally been revealed and the market reaction has so far been as expected. The Fed’s quantitative easing (QE) program has garnered almost all of the market attention that it even has taken the front seat to the U.S. midterm elections. Fed announced that they would purchase an additional $600bn of Treasury securities, with the overall purchases reaching $850mn-$900mn in 8 months, including some $250-300bn worth of reinvestments from the previous program. The assets purchased will have an average duration of between 5 and 6 years, which is the single feature of the program that may have created disappointment. Almost half of the assets will have a maturity of 5 to 10 years, while the 40% is planned to be of maturities between 2.5-5 years. Following the FOMC statement, the 2-year Treasury yield has slid to a historical low of 0.34% and the Fed funds futures indicate that no rate change is expected until the last quarter of 2012. Note that this is the case, despite the absence of any enhancement to the Fed’s phrase regarding the necessity of ‘low levels for the federal funds rate for an extended period’. Note also that ‘the Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed.’ This would leave the door open to changes in both directions. Moreover, just as the rate decisions are subject to growth and employment outlook, the above phrase assumes conditionality for the QE size and provides some flexibility to the Fed. As shall be recalled, the key properties of an ideal QE program mentioned in our comment published on October 12th listed exactly the same aspects. Therefore, the decisions did not come as a surprise. Accordingly, the financial markets have now returned to their positive trend and to the strong risk appetite environment. It seems that going forward, we will keep discussing about the appreciation pressure on TRY, as well as how further the country risk premiums and interest rates would fall, accompanied with the new record highs in the stock markets.
The Fed decisions would no doubt intensify the pressure on the emerging country central banks, which have already been dealing with the rapid capital inflows to their countries that result in appreciation of local currencies and has the risk of generating asset bubbles. Amidst this contentious environment, Turkey stands at a different point, being concerned with rapid domestic credit expansion and searching ways to suppress it, unlike the U.S. Turkish Central Bank Deputy Governor Basci told in a conference last week that Turkey should impede the credit expansion in its economy which has enjoyed a fast rebound after the global crisis and that new policy instruments may be required for that purpose. This was not much unexpected and the banking sector should be ready for creative and new tools, atop of the already introduced measures such as the increase in required reserves, abolishment of interest paid on reserves and the increase in the KKDF (Resource Utilization Support Fund) rate on consumer credits. The road-map regarding to these new instruments may be disclosed at the 2011 Foreign Exchange and Monetary Policy report due to be released at the beginning of the next month, the latest. However, the inflation pattern would play a critical role in order to give the Bank enough space to follow their plan.

Turkish Consumer Price Index rose by 1.83% m/m in October, overshooting the consensus, while the deviation from forecast was mostly due to the significant jump of 4.5% in food prices. Accordingly, the annual food inflation reached 17.1%, remaining above the Bank’s year-end assumption of 10.5%. The cumulative increase in food prices in the last two months of the last year was 7.7%, meaning that the prices should remain unchanged in the rest of this year in order to bring the annual inflation in line with the Bank’s forecast. Given the seasonal and other factors, this scenario seems quite unlikely. The unprocessed food prices that surged significantly over the last three months (from 8% to 31% y/y) have been the reason behind the elevated food component. In essence, the high level of volatility in food prices is one of the major obstacles against the process of disinflationary goals. A Central Bank study that covers the period between 2006-2009 shows that the volatility of monthly food price inflation in Turkey is 4 times of the EU-27, while this ratio goes up to 6 for the unprocessed food component, with Turkey having a higher volatility of monthly unprocessed food price inflation than each of the EU27 members. It should be noted that the volatility is two-sided and the inflation can fall as rapidly as it ascended. Nevertheless, recognizing that this would not happen all of a sudden, I revised my year-end CPI forecast to 7.7% from 7.2% due to the change in our food price assumptions. On the other hand, I continue to anticipate CPI easing to 6.0% by the end of 2011 with the help of the taming in food segment.

Contrary to the increase in the annual headline inflation, there were declines in the core indicators. The annual price change of the Central Bank’s favorite core indicator (excluding food, energy, gold, alcoholic beverages and tobacco), namely the “core-I” index, declined by a significant 1.2 pp m/m to 2.5%. While this is the sixth consecutive fall in annual core inflation, current level is its lowest level in the history of the series that started in 2003. Furthermore, the annual price change in services declined by 0.4 pp to 4.2%, again the lowest in the history of the series.
All in all, there is no doubt that the underlying inflation proceeds at a benign pace. Yet this does not change the fact that there is this disturbingly wide gap between the headline and the core. The Central Bank is also concerned with this issue by emphasizing the risk of jeopardy in pricing behavior. The Bank warns that they may hike earlier than planned, in case this risk materializes. On the other hand, the Central Bank seems quite comfortable here, as a recent CBRT working paper titled “A New Core Inflation Indicator for Turkey” concludes that ‘...when inflation deviates from core inflation, it converges back to the core inflation; but not the other way around.’ However, this does not necessarily mean that the headline CPI would converge to 2.5%. The empirical data show that even though there are cases where headline converges to the core, the two indices happen to meet somewhere in the middle following a significant decoupling.

Therefore, while the leading indicators warn against some revival in the economic activity going forward, it would unlikely ring any alarm bells in the Central Bank with such an encouraging underlying inflation trend. While this data is supportive of the already dovish stance of the Central Bank, we continue to expect the rate hikes to start in the last quarter of next year and amount to 100bps in 2011.