Kicking The Can Down The Road...

We were one of the very first macroeconomics teams to have stressed the need for tightening prior to the October MPC meeting, as outlined in my article entitled “Hawks to the Fore” published on October 17. Moreover, after the MPC’s decision to widen the interest rate corridor, we underlined that this was the least the CBT could do for the time being, also reiterating our view that the inflation outlook and the TRL still warranted a much tighter stance than the current one.
However, the CBT appears satisfied with the outcome of the new framework since its execution as of October 21; i.e. a stronger TRL and higher loan rates. The average O/N repo rate has jumped to 10.0% as of then, compared to the previous 1-month average of 6.2%. Moreover, after several days of implementation, the CBT Governor indicated at an investor meeting that they did not intend to keep O/N rates at unnecessarily high levels in normal market circumstances, provided that credit conditions remained tight and the TRL stabilised at around current levels. In our view, this statement attests to the flexible and temporary nature of the interest rate corridor policy, also indicating that the CBT continues to kick the can down the road.

As we have been underlining from the very start, we consider this strategy viable and effective, but do not think the divergence of the O/N rate from the policy rate is sustainable for long, as the reference rate in that case loses its significance. Normally, the CBT’s tightening stance would justify an outright rate hike -- not the current “hike in disguise”, we think. Although, one might still give the CBT the benefit of the doubt, on the premise that the reluctance to use the policy rate hike mechanism is driven mainly by global economic uncertainties, it seems more probable that this preference will be perceived as the main flaw of the tightening stance and its adequacy will be increasingly questioned down the line. Therefore, we think the CBT will need to review this policy after a few months’ implementation and possibly take a clearer stance on the policy rate (or policy mix) path in the first Inflation Report of 2012 due to be published by end-January the latest.

In an inflation targeting regime where there is a small output gap -- and irrespective of whether the regime is flexible or not -- a central bank should act in a permanent tightening direction only when there is significant deterioration in inflation expectations, as gleaned from expectations surveys or market-based indicators, such as in terms of bond yields and breakeven inflation* in CPI linkers. The reasons underlying higher inflation expectations (depreciation of the currency or higher import prices) are of no significance for a central bank. Three indicators are crucial in this respect: 12-m and 24-m forward-looking CPI expectations from the CBT’s twice monthly survey; 2-year or benchmark bond yields; and B/E inflation level for the CPI linkers. Currently, all of the three indicators are at recent highs. However, this is not a fresh development and more importantly the deterioration has not been significant after the administrative price shock in October and the CBT’s upward revision of year-end CPI forecasts. For now, this is somewhat relieving, but we should follow them closely, as they remain susceptible to macro surprises, going forward.

Having said that, we tend to take a fairly lenient view of this somewhat controversial monetary policy framework the CBT has been implementing since November 2010 in the remainder of this report.

Evolution of “Monetary Policy A La Turca” in Brief

One of the most crucial lessons to have emerged from the global crisis on monetary policy is that failure to safeguard financial stability might lead to the disruption of macroeconomic and price stability in the medium term. In this framework, the notion that central banks should not remain oblivious to asset price bubbles or to risks accumulating in the financial system has been gaining widespread acceptance. This situation has prompted a number of central banks to integrate measures aimed at safeguarding financial stability into the framework of monetary policy, setting the stage for non-conventional monetary policies, which have started to be used extensively by advanced and emerging countries’ central banks.

The Central Bank of Turkey (CBT), one of the first central banks to have mentioned financial stability, has launched works to expand and activate the set of instruments necessary for a monetary authority targeting price stability along with policies intended to defend macro financial stability, as of mid-2010. To this end, the monetary authority has decided to use the reserve requirements and the interest rate corridor (the difference between ON/ borrowing and lending rates) as other instruments alongside the policy rate. In a bid to enhance the effectiveness of reserve requirements as a policy tool, the CBT has ceased paying interest on the reserve requirement liabilities of the banks.

This new approach envisaging the usage of more than one policy instrument by the CBT entails certain risks, such as i) misunderstanding (emphasis on financial stability might create the misperception that deviations from the inflation target might be tolerated); ii) facing difficulties related to communication (the absence of a clear-cut theoretical framework or concrete findings for the effectiveness of non-conventional monetary policy instruments). Moreover, the fact that the Bank has deliberately created uncertainty to deter short term capital inflows at the start of the application, and has predicated its monetary policy communication on the concepts of “policy mix” and “monetary tightening”, rather than providing guidance on interest rate path as in the past, prompts the perception that it will take some time for market players -- accustomed to the previous policy implementation -- to comprehend and accept the new approach.

Although the monetary policy mix concept might seem complicated at first glance, it may be considered as a more flexible form of inflation targeting. While the principal criterion in monetary policy decisions is again deviation in inflation expectations from target, this time macroprudential tools are also brought into the equation, so as to contain financial risks. Hence, monetary policy stance is determined by short term policy rates, as well as the net balance of other variables determining monetary conditions, such as reserve requirement rates and the liquidity situation in the market. How and in which direction policy instruments will be utilised, on the other hand, is designated by price stability and factors affecting financial stability.

This graphical representation of the monetary policy recently introduced by the CBT depicts a variety of policy responses by the monetary authority towards fulfilling its mandates of attaining price and financial stability. While the CBT has started to utilise this framework in its communication as of the final months of 2010, the evolution of policy mix as of then is traceable from the graphical representation above.

It should primarily be underlined that the CBT’s primordial goal is the attainment of price and financial stability, the two main axes of monetary policy. In terms of graphical representation, this would imply being at the crossing point of the four main blocks, i.e. meeting the targets, while corresponding to a neutral stance from a monetary policy standpoint. The choice of monetary policy response hinges on which of the four main blocks we are at (or at which of the four main blocks the Bank perceives us to be). While the state of price stability is determined by whether inflation is on an accelerating or decelerating tendency, from the standpoint of financial stability, key determinants are whether credit growth is on the rise or on the decline. As an example, the policy response given as of November 2010 -- at a time when inflation was on a downward course yet credit growth on the rise -- was a combination of tightening of policy tools other than interest rates (liquidity withdrawal and increases in reserve requirement ratios) and easing in policy rate; i.e. corresponding to Block A.

In the framework of the new monetary policy implementation, there have been two shifts in blocks -- one of them quite recent. The first one of these came right on the heels of the July Inflation Report, when an extraordinary MPC meeting was held amid mounting uncertainties surrounding the Eurozone. The monetary authority then drew attention to global risks as well as to the prospect of a recession in the domestic economy, conveying the view that all instruments would be used in an expansionary manner. The decisions that followed proved consonant with this message, implying a transition to Block B, i.e. the state where policy rate and instruments other than interest rate are employed in an expansionary mode. However, this positioning proved short-lived. With the upward tendency in inflation gaining pace and the ensuing shock to administered/guided prices in October adding further momentum to price increases, the Bank was compelled to switch to a tighter monetary stance. However, this monetary tightening was not in the form of a direct policy rate hike that would comply with Block C, rather through allowing the O/N repo rate to drift higher than the policy rate while expanding the interest rate corridor. Instruments other than the interest rate, on the other hand, were used as expected, with the reserve requirements imposed on TRL liabilities scaled down by 200bp on average, in a bid to alleviate the shock on deposit and credit costs.

It is worth underlining that actual monetary tightening was not as strong as the perception created by O/N repo rates initially hovering at and above 10%. From the perspective of a bank’s funding cost, more than the prevailing rate at the O/N repo market, it is the portion of the funding that the CBT provides via the 1-week repo auction at the 5.75% policy rate. From this standpoint, it is observed that a major portion of the funding need is still met through this channel. Based on our calculations, which incorporate the funding banks receive through mutual funds and repo transactions with clients, alongside the funding provided by the CBT channels (1-week repo, market making, lending), the average funding cost has increased up to 7.8%, up 180bp, from about 6% prior to this implementation. The effect would have been similar, had the tightening been through the policy rate. The only difference is that tightening via the policy rate tends to be more permanent, while that through widened interest rate corridor, given its flexible nature, might prove temporary based on the market conditions that follow.

The fact that the CBT has opted for this mode of tightening might be attributed to the prevailing global uncertainties in the current environment and the monetary authority’s need to gain time for better visibility. In its latest Inflation Report, the CBT declared its 2012 inflation estimate at 5.2%, based on the assumptions that “the gradual slowdown in consumer loan growth continued and that in the framework of the policy decisions made in October, monetary conditions were markedly tightened in the final quarter of the year”. Given the ambiguity of this message sentence in the section of the report devoted to policies, it does not appear possible to clearly discern until when this seemingly temporary tightening will continue and the nature of the stance that will replace it in the new year. In the coming period, barring a marked deterioration in forward looking inflation expectations, we reckon the Bank will be inclined to sustain this strategy. Otherwise, we believe the Bank will need to render monetary tightening permanent through the policy rate.