Flexible Inflation Targeting...

MPC meeting (July 21st) is likely to bring some important changes to the current stance of the CBT which are signalled beforehand during the meeting with economists in Ankara on July 5th… One reason for this manoeuvre is simple. This is the month when the CBT publishes quarterly inflation report (July 28) and thereby review all of its macro projections that could have an impact on policy outlook. The message which was given for the likely path of the policy mix (limited additional tightening in 2H11 that will bring the loan growth to 20-25% by YE11) in the previous report is clearly outdated and has to be renewed in our view. The second and third reasons are related to the CBT’s assessment about the ongoing uncertainty regarding the global economy and the slowdown in domestic economic activity. The CBT had mentioned the risk scenario regarding a deterioration in global outlook (“should the problems in advanced economies intensify, leading to contraction in domestic economic activity, this may require an easing in all policy instruments”) at the July 5th meeting with economists, which a sign that it has more weight within the alternative scenarios. Therefore, it implies the reversal of the contractionary impact of policy mix --probably through lower RRR-- in the case of sequential contraction in the domestic economic activity. Note that the CBT anticipates GDP remaining flat in 2Q in seasonally adjusted terms as suggested by the charts presented at that meeting. Our preliminary estimate for 2Q also is inline with their forecast. We think the observed deceleration in economic activity was mainly a consequence of the weakness in external demand, while there has been no visible slowdown in domestic consumption. However, we would beg to disagree with the CBT if the above mentioned risk scenario soon becomes the base scenario, as we still do not see any hard evidences indicating that there is a permanent loss of momentum. On the contrary, all leading indicators (PMI, capacity utilisation, consumption index) for June are recovered from their troughs in May. Nevertheless, the fresh concerns about highly indebted countries of Eurozone, the ongoing weakness of job creation in the US and the Chinese inflation remain as obstacles to a visible acceleration in the global economy. All in all, it seems that the outlook for the domestic economic activity will not be changed significantly in the upcoming MPC statement and in the Inflation Report. Probably, the CBT will not change its output gap forecast notably either, despite higher than expected growth in 1Q. Therefore, the MPC is likely to continue to lean on weak external demand and might reiterate its view that the aggregate demand conditions do not indicate an overheating.

CBT will tolerate the core inflation increase… In due course, the CBT described the inflation outlook as benign at the July 5th meeting, despite the recent pickup in core inflation, hinting that there will be no noteworthy change in the CBT’s inflation forecasts. Note that, in the previous Inflation Report, the CBT revised up its inflation forecast to 6.9% for 2011, while keeping 2012 inflation forecast almost unchanged at 5.2%, under their main assumptions for average oil price ($115), annual import prices increase (16.2%) and food inflation (7.5%). This would imply a new year-end CPI forecast in the vicinity of 7% as these assumptions are still valid and annual CPI as of June converged again to the path foreseen in the April Inflation Report. We also project inflation will decelerate towards 5.5% in 3Q11 and re-accelerates to 7% by YE11, as food inflation tends to fluctuate massively throughout the year. However, we are more concerned about the upward trend in core inflation in the remainder of the year. Higher import prices, as well as strong domestic demand are expected to further lift the core inflation in the coming months. We foresee that the CBT’s favourite core indicator (I) would increase (from 5.27% in June) to 6% in 3Q, and 6.5% at the end of 2011.

Moreover, the CBT discloses its projection for one of the core inflation measures (CPI excluding unprocessed food, tobacco and alcoholic beverages) in the Inflation Report and we notice that this core inflation has already breached above the upper band of the forecast range as of June (Graph 1). Nevertheless, CBT still sees this increase as a relative price adjustment of tradable goods rather than deterioration in the overall pricing behaviour and it seems that the CBT attaches more importance to the trend of core indicators rather than the annual increase in those indicators that reflects unfavourable base effect. As a trend indicator, CBT uses the seasonally adjusted annualized 3-month averages of core-H and core-I, as well as services prices. As of June, which is the latest available data, all of those indicators are trending downwards and two of them are around 5.5% target for the headline CPI (Graph 2). Although, the recent TRL depreciation should warrant a cautious stance due to the potential pass-through effect on prices, the CBT is more inclined to tolerate further YoY increases in core indicators unless their trend turns north.

Loan growth could slowdown, but not to 25% without further BRSA measures... For the other important issues like loan growth and current account, the Bank remains confident by reiterating that the loan growth rate will be observed to fall to 25% in the last quarter of 2011 and the current account deficit will start improving from 4Q11 onwards. Indeed, at first sight, it seems that 2H11 could turn out closer to the desired picture, with another round of increase (240 bps) in consumer loan rate (Graph 3) after the mid-June decisions by the BRSA on general provisions and to some extent due to the favourable base effect originated by the loan demand brought forward in anticipation of higher costs. Moreover, the loan growth is seasonally the lowest in 3Q and tends to be roughly half that of 2Q. However, the trend indicator that the CBT follows (the 4-week average trend growth in consumer loans) remained above the 2006-2010 average in the last couple of weeks (Graph 4). According to our calculations, the weekly changes in line with the 2006-2010 average in the second half would imply around 35% loan growth at the year-end --not much different from the current trend. We think, the year-end target will unlikely to be within reach, without further measures from the BRSA.

C/A deficit could get worse before it stabilises… Elsewhere, on the back of the strong recovery in domestic demand and higher commodity prices, 12-m rolling CA deficit hit a record high US$68.2bn as of May’11, corresponding to 8.8% of the GDP. Similar to some other macro indicators, there are sings of moderation in imports recently. Based on our calculations, non-energy imports have been declining in seasonally-adjusted terms during the last two months. However, this evidence neither guarantees a steady downward trend, nor seems sufficient to allay concerns over current account balances. Moreover, exports also declined in seasonally-adjusted terms due to slowdown in 2Q in the global economy. We expect the 12-m cumulative CA deficit to GDP ratio to peak around 9.5 - 10% in 4Q11. This would keep Turkey vulnerable to sudden stop risks in the capital flows on the back of rising concerns about Eurozone. However, the financing of the deficit will not be a problem with the current status of global liquidity amidst the revival of QE3 discussions after FOMC minutes.

Can TRL make the necessary adjustment?.. The current monetary policy stance, deteriorating C/A deficit and lower global risk appetite will certainly keep depreciation pressure on TRL. In the absence of measures --including fiscal ones-- from other institutions, weaker TRL would help the adjustment process of macroeconomic imbalances (wide difference between the growth rates of domestic and external demand) to the extent that CBT can tolerate the overshooting of CPI target. That means, in case of excessive depreciation, i.e. above 2.0 basket (0.5$+0.5€) level, CBT may further lower the daily FX purchases, suspend FX auctions or narrow the interest rate corridor by increasing the O/N borrowing rate from 1.5% in a bid to make TRL attractive for carry trades.

No significant help from fiscal side… Last but not the least, the CBT continues to see the fiscal discipline as essential to control the C/A deficit but it looks like they do not pencil tax hikes on consumer goods and they are probably contented with governments’ saving the extra revenues from stronger economic activity and debt restructuring. Therefore, we have to keep a close eye on central government primary expenditures as % of GDP from now on, to evaluate the fiscal discipline.

To conclude, the CBT is still far away from returning to orthodox policies and more importantly they are inclined to tolerate further increases in annual core inflation indicators unless their trend turns north. For the moment, this means the maintenance of current policy stance. However, if the risk scenario related to global economy becomes the base scenario soon, then there is a significant probability of dropping the “tightening” bias in the monetary policy stance. Although we acknowledge that the global and local economic activity has been moderating in 2Q, we think there is still a decent probability that this slowdown could prove temporary. In that context, we decided to wait for the new Inflation Report to revisit our call for 100 bps hike in 4Q, although we are aware of the fact that the consensus perception from the meeting in Ankara is geared towards “no rate hike this year”. In any case, we do not expect RRR hikes in TRL or FX liabilities in 2011.