Capitalising on Global Trends…

The state of indecisiveness that characterised market sentiment in the early months of the year has given way to drastic changes in pricing as of the end of the first quarter. Apprehensions as to the strength of global recovery and Bank of Japan’s unprecedented quantitative easing decision have set the stage for dramatic declines primarily in commodity prices and long-term bond yields. This, on the other hand, sets an extremely supportive backdrop for Turkey’s economy and financial markets. Continuation of easy global liquidity conditions -- at a low cost -- and not leading to a bubble in asset prices is probably a dream scenario from Turkey’s perspective.

It appears that sub-potential growth once again in the first quarter and a downward course in commodity prices, most notably oil, will lead the deterioration in Turkey’s foreign trade and current account balances -- triggered by the recovery in domestic demand -- to be contained. It seems to us that the most recent decisions by the CBT are intended entirely “to weaken the link between capital flows and domestic macroeconomic variables such as credit and current account deficit”, and that the monetary authority has been relieved of the pressure from rate cut expectations, thanks also to a supportive global backdrop. We continue to believe that this general outlook reinforces credit rating upgrade expectations, potentially allowing agencies other than Fitch the opportunity to raise Turkey to investment-grade category.

Looking at the current state of affairs, the principal leading indicator, PMI indices, have continued to drift lower in March on a global scale, following the retreat in February, which attests to the slowdown in global recovery. As for the Turkish economy, growth in 1Q13, albeit definitely above the previous quarter, will nonetheless continue to undershoot potential growth rate. We did acknowledge that these developments could somewhat weigh on 2013 growth perceptions, though it is noteworthy that expectations still remain unchanged at 4.2% levels, based on survey findings. Despite a minor increase in YE13 inflation expectations towards 6.6%, 12- and 24-month forward looking inflation expectations remain closer to 6.0%. Nevertheless, considering the appreciation pressure on the TRL and sliding commodity prices, a deterioration in inflation expectations appears quite unlikely, in our view. Finally, these developments warrant minor changes to our forecasts, which we also provide in this report.

As for markets, we attach significant likelihood to a retest of earlier record highs for the BIST in the short term, buoyed by Moody’s rate hike expectations. Even in the event that expectations are fulfilled, however, we see it likelier for the market to switch to more of a range-bound trading pattern. Regarding interest rates, intervention by the Bank of Japan and actions by the CBT -- keen not to miss this opportunity -- have created a drastic change in outlook. While we continue to expect interest rates to follow an upward slope until the year end, compared to our earlier forecasts, we now expect increases to be more gradual and limited in magnitude. On the exchange rates front, given renewed intent by the CBT to take all measures necessary to surmount any pressure from capital flows, we continue to expect the currency basket to fluctuate within a band of 2.05 - 2.15 throughout the year, and not to dip below the 2.05 mark.

MPC Preview - All Roads Lead To Rome

The fourth Monetary Policy Committee (MPC) meeting of 2013 will be held on Tuesday, April 16. We perceive Bank of Japan’s (BOJ) unprecedented quantitative easing decision dated April 4 as a major “game changer”. This should also help alleviate uncertainties posed by the direction of capital movements, regarding which the most recent MPC meeting statement included the following prediction: “The Committee foresees that tighter liquidity policy along with weaker capital inflows will slow down credit growth”. Yet, the ensuing meeting minutes included the following statement, leaving the door open for the monetary authority to act in the event that the opposite case prevailed: “Necessary measures will be taken through liquidity policy, ROM, and reserve requirements should capital inflows re-accelerate”. In short, we expect the CBT to revert to its commonly known base scenario and to reiterate its following stance: “In order to contain the risks on financial stability due to strong capital inflows, the proper policy would be to keep interest rates at low levels while continuing with macroprudential measures”. To this end, we attach significant likelihood to a 50bp cut to both the policy rate and the interest rate corridor. Additionally, more dramatic increases in FX and TRL reserve requirements compared to early practices (50bp and 25bp), in a bid to intensify the sterilisation of capital inflows, could be expected, in our view. Such a move, on the other hand, would reduce the possibility of a new increase in reserve option coefficients (ROCs). Our forecasts are predicated on the assumption of a somewhat more aggressive stance by the CBT regarding interest rates and macroprudential measures compared to the consensus view.

In the early days of the month in progress, at a speech in Mardin, CBT Governor said a measured cut to the policy rate may come on the agenda should the REER top the 120 threshold. Indeed, according to our calculations, the REER is likely to exceed the 120 mark significantly in April if the TRL continues to trade at current levels (2.06) against the FX basket. Moreover, additional quantitative easing decisions by developed countries set the stage for policy rate cuts by emerging market (EM) central banks. The average policy rate of ten EMs -- that are closely monitored by the CBT as well -- has retreated to 5% levels at this point. The CBT, keen to maintain its relative position and to mitigate the appreciation pressure on the TRL, may seize this opportunity to eliminate the prevailing difference in interest rates.

However, the CBT would run the danger of being perceived to have apprehensions about growth, and using the REER as a pretext to deliver a policy rate cut, especially if such as decision is not counterbalanced by macroprudential measures. Therefore, the way the monetary authority chooses to communicate these decisions will be more important than ever to contain potential loss of credibility.

Investors might also recall that the CBT had withdrawn excess liquidity a few days before the March MPC meeting and embarked on active liquidity management thereafter; thus, repo rates had risen significantly. However, repo rates have started to fall sharply over the last few days, which could be considered as a probable end to liquidity squeeze ahead of the April MPC meeting. This might also imply that a borrowing rate cut will accompany a policy rate cut at this meeting, to ease the appreciation pressure on the TRL.

Ground Control to Major Tom…

The month of February will probably be viewed, in retrospect, as a time when the somewhat excessive exuberance of the preceding months subsided and a sense of realism pervaded the market. But isn’t that generally the case anyway: hopes that turning the page to a new calendar year will usher in earth-shaking shifts give way, all of a sudden, to the realisation that economic trends do not change all that quickly. There is nothing disconcerting about that, though... It could even be considered a healthy correction, as it might pave the way for favourable market trends to be based on more solid foundations.
A similar pattern is already evident in global markets: the year started with expectations of an overall recovery, which promptly reflected on long-term bond prices, while stock exchange indices started testing 5-year highs... However, judging from the significant asset price gyrations, no decisive market trend seems in place for now. Regarding markets, news flow from the US will likely be of greatest significance in the short haul. While efforts in the US to find a lasting solution to the automatic spending cut slated to take effect on March 1, 2013 -- following a 2-month deferral as of the new year -- will be high on the agenda until the end of the month, opposing views within the FOMC as regards the FED’s open-ended asset purchases will also be keenly eyed.

As for the Turkish economy, we see no reason to alter our overall view of the year 2013, as fine-tuning in policy implementations will likely suffice in what seems to be essentially a year of safeguarding the gains. One key source of risk is for growth rate to fall substantially short of potential growth rate, as in 2012: such a development would be greeted with greater tolerance by the CBT -- intent to protect the improvement in external balances -- though a similar approach is not to be expected from the political administration. Such a situation would prompt limitations to the flexibility enjoyed by the CBT in terms of shifting its focus to different targets when necessary -- the predominant source of its effectiveness -- in the framework of its multi-instrument, multi-target monetary policy implementation. As we mentioned earlier, the CBT, which bases monetary policy communication on three intermediate variables (inflation expectations, loan growth and real exchange rate), has diverted its focus recently to more imminent risks such as acceleration in loan growth and appreciation pressure on the TRL, given a lack of threats from inflation expectations to medium-term inflation outlook.

From a short-term perspective, while 4Q12 growth data point to contraction in all key markets including the US, PMI indices -- a key leading indicator -- suggest global recovery will gain traction, bolstering hopes for the future. On the other hand, growth in Turkey has remained lacklustre in the last quarter -- confounding expectations -- and leading indicators for January do not quite support hopes of a recovery. Yet, this does not seem to affect growth perceptions for 2013, as the survey median remains unchanged at 4.2%. Moreover, although inflation has topped 7% in January with tax adjustments, deterioration in inflation expectations should be limited as long as volatility remains subdued in exchange rates and commodity prices. 

As for financial markets, our view expressed in our previous monthly report that the stock exchange index was in overbought territory was validated by the ensuing correction. In our view, selling pressure will persist for some time, subsequently leading to more of a range-bound bias. Regarding interest rates, on the other hand, the upward trend should continue, to be felt more on the long end of the curve. As for FX rates, given the CBT’s well-known stance and the framework drawn for real exchange rates, we continue to expect the TRL/currency basket not to fall below 2.05 and to fluctuate within a band of 2.05 - 2.15 through the course of 2013.

Three-way Betting

The second Monetary Policy Committee (MPC) meeting of 2013 will be held on Tuesday, February 19. While we will be providing our views as to potential decisions by the MPC at this meeting in the following paragraphs of this note, we first need to underline that the recent emphasis by the CBT on monetary policy decisions being “data-dependent” has increased the uncertainty compared to before, thereby raising the possibility of a surprise decision by the monetary authority. This is because data are objective, while analyses are subjective, and differences in interpretation among market players and the CBT might prove more substantive than ever.

Let us remind investors of key messages provided by the CBT at the January MPC meeting and the subsequent Inflation Report (IR): “Inflation forecasts assume that monetary policy decisions are data dependent. In other words, it is envisaged that credit and exchange rates follow a stable course and aggregate demand conditions are kept at levels that do not exert upside pressure on inflation. Accordingly, in response to incoming information regarding price stability and financial stability; short term interest rates, liquidity instruments, and macroprudential measures are set in a flexible and coordinated way. Therefore, the forecasts envisage an outlook where macro financial risks arising from the recent surge in capital inflows risks are contained. Forecasts are based on the assumption that annual loan growth rate will hover at around 15% and there will be no significant change in the real effective exchange rate. (…) Financial conditions index has continued to ease with rapid capital inflows, improving credit supply conditions, and accommodative liquidity policy. These developments point to the risk of further acceleration in credit and domestic demand for the forthcoming period, necessitating a cautious stance against macro financial risks. Therefore, in its first monthly meeting of 2013, the Committee highlighted the faster-than- expected credit growth and signalled that macroprudential measures might be continued should this trend persist.”

Under the light of these principal messages and despite the absence of any hints by the MPC at the January meeting, expectations of a “measured adjustment to the interest rate corridor” and continuation of RR hikes do seem reasonable, in our view, considering recent data flow and most notably changes in the real effective exchange rate (REER) -- a closely followed intermediate variable by the CBT -- and loans.

On the other hand, looking at the same data juxtaposed against the macro setting, and also considering Governor Basci’s remarks following the issuance of the IR, a wait-and-see approach by the MPC also seems somewhat plausible. Investors might recall that in the Q&A session of the IR meeting, Basci had stated that the measures taken so far on the RRR seemed sufficient to rein in loan growth at this stage, adding that the loan growth target was not too rigid. On the other hand, the REER had exceeded the “overvalued” threshold of 120 identified by the CBT in January, backing the monetary authority’s last action of a 25bp cut at the lower band of the interest rate corridor. Month-to-date in February, the REER continues to hover at about the January level, still within the CBT’s tolerance interval, as projected through 1.5-2.0% real appreciation annually. Based on our inflation forecast, the REER is likely to fluctuate at around the 120 mark in February, unless the TRL weakens to beyond 2.065 against the currency basket through the reminder of the month.

Finally, from today’s vantage point, neither the overshoot in inflation nor the undershoot in growth is expected to trigger a change in the CBT’s policy stance. Monetary policy is currently being shaped by the real performance of the TRL and the course of loan growth. Note that a cut at the lower band is aimed solely at deterring capital inflows, and is not expected to provide any additional stimulus to economic activity. Otherwise, we expect the CBT to maintain the policy rate at the current level.

Therefore, we think the following three courses of action lie before the CBT: i) Actions similar to January MPC meeting resolutions; i.e. shifting lower the interest rate corridor in a measured way, and implementing minor hikes in TRL/FX RRRs; ii) Maintaining the status quo, but providing the message that they stand ready to act, if need be; iii) A symbolic tightening in RRRs. We attach slightly higher probability to the second option, while acknowledging that a symbolic tightening in RRRs per se would strengthen the cautious stance regarding financial stability.

Last but not least, we attach significant importance to press reports claiming a lack of coordination between the CBT and the Banking Regulation and Supervision Agency (BRSA) and the subsequent joint denial by the institutions. Actually, we had emphasized the significance of coordination in our earlier assessment: “…The reserve requirement hikes introduced by the CBT within the first half of 2011 had not proved that effective in tempering loan growth; rather, loan growth was restrained eventually thanks to the measures adopted by the BRSA in June. While it might behoove the BRSA to act in a similar way in the coming months, we reckon the lesson hopefully drawn from the 2011 experience might lead to improved coordination among relevant institutions….” In this sense, the following joint statement by the CBT and the BRSA is relieving, in our view: “…Regulations that are relevant to more than one institution are discussed at the Financial Stability Committee level and any decision is made following mutual exchange of opinion. Our institutions will continue their works, as before, on the basis of rapport and mutual cooperation.”

Sometimes the Best Offense Is a Good Defence

The New Year kicked off with a distinct strengthening in global risk appetite, as the fiscal cliff was averted, albeit temporarily, thanks to a last-ditch tax revenue deal, along with a two-month reprieve to resolve the outstanding debt ceiling and spending cut issues. Not that the minutes of the December FOMC meeting left investors unfazed… While it was reiterated in the minutes that open-ended asset purchases would continue in the short term, the fact that some members cited the unfavourable consequences of QE, expressing their views that purchases could be pared back or even terminated mid-year, i.e. somewhat earlier than expected, provoked scepticism. The first reaction to this news unsurprisingly came from 10-year US treasuries, the yields on which jumped up to 20bp. Though the ensuing turmoil appears to have subsided in recent days, the fact that Governor Bernanke failed to clarify this matter in his first speech to follow the publication of the minutes meant the continuation of uncertainty, suggesting related developments should be closely monitored from the standpoint of market equilibria. As for the Turkish economy, we reiterate our view that the overarching theme of 2013 will be the preservation of gains. As such, we feel fine-tuning, rather than drastic changes in policy implementations, will suffice. The implication for the Central Bank is the establishment -- and even more crucially the safeguarding -- of an environment conducive to balanced growth. Besides, the Bank has signalled balanced growth for 2013 with its following statement: “We will let domestic demand contribute to growth to the extent that external demand recovers”. It will continue to communicate any progress to this end via the following three intermediate targets: inflation, loan growth and the real exchange rate. At this stage, given a lack of threats to medium term inflation outlook in terms of inflation expectations, the Bank appears more likely to focus on more imminent threats such as acceleration in loan growth and appreciation pressure on the TRL. Loan growth, which closed last year somewhat above targets and started the New Year with unabated strength, appears to be the key challenge for the Bank. To the extent that loan growth deviates from targets, the possibility of additional burdens on banks from the CBT and/or the BRSA will have increased. Nevertheless, we remain of the view that the Bank will not consider the loan growth target as a rigid boundary, rather that it will evaluate it with a flexible approach, taking into consideration its reflections on domestic economic activity. From a short term perspective, on the other hand, disclosures by the ECB suggesting the worst was left behind, and Spanish bond yields dipping below 5%, have contributed to an upbeat start to the year. While PMI indices, which we consider among the most crucial leading indicators, signify sustained recovery -- that is stronger in China and the US, and less so elsewhere -- the nearest hurdle that needs to be surmounted so that the recovery may gain traction appears to be the fiscal policy uncertainty in the US, which should be resolved until mid-February. As for Turkey, we observe some strengthening in growth as of the last quarter of 2012, though this still seems short of the potential growth rate. Initial growth rate forecasts for 2013 appear to average at around 4.2% levels. On the other hand, we reckon inflation may once again edge closer to 7% levels in January along with tax adjustments, though provided that the prevailing muted volatility in FX rates and commodity prices is sustained, we reckon any deterioration in inflation expectations seems unlikely. Initial survey findings point to 6.3% for YE13 average CPI expectations. As for markets, while the ISE benchmark index continues its venture “into uncharted waters”, we reckon we might have reached overbought territory and the odds of a shift henceforth to a sideways pattern appear to have increased. In terms of interest rates, on the other hand, the rebound we anticipated from historic lows has occurred and we now expect the upward trend to continue, and be more pronounced at the longer end of the yield curve. Regarding FX, in view of the CBT’s known stance and the framework it has drawn for real exchange rates, we do not expect the currency basket to slip below the 2.05 mark, rather to fluctuate within the 2.05 - 2.15 band through the course of the year.

Wall of Money in Land of Honey (MPC Preview)

The second Monetary Policy Committee (MPC) meeting of 2012 will be held on Tuesday, February 21. We and consensus expect no change in policy rates or in other monetary tools. However, given strong portfolio inflows in January and significant easing in financing conditions, the CBT may let the banks keep a greater portion of TRL RR liabilities in FX, in order to accumulate FX reserves, in line with their guidance at the latest investor meeting in Ankara. Currently the upper limit is 40%, but according to the CBT, the banks are utilising 35% of this facility for the time being.

The CBT may also retain the key message in its statement; i.e. “tight monetary policy stance should be maintained for a while in order to keep inflation outlook consistent with the medium term targets”. Moreover, the monetary authority could underscore once again the merits of preserving the flexibility of monetary policy, through referring to adjustment of TRL funding via one-week repo auctions in either direction, depending on developments in credit, domestic demand, and inflation expectations. Furthermore, we know from the last Inflation Report that CPI forecast of 6.5% is based on the assumptions that tight monetary policy stance will be sustained for a while; annualised loan growth rate will hover at around 15%; and the Turkish lira will display a mild appreciation trend.

However, the CBT may also start building the foundations of an alternative scenario of “strong inflows”, implying a strengthening in capital inflows to Turkey after the January FOMC decision, ECB’s LTRO, and new additions to QE by BoJ and BoE, though this may not necessarily be mentioned in the brief statement to be published after the MPC meeting. If this does turn out to be the case, however, it would be the exact opposite of the market conditions (outflows/weak inflows) that prevailed within October-December 2011. Note that the CBT has shared its possible monetary and macroprudential reactions for both cases in previous presentations.

Therefore, we expect the CBT’s responses to strong capital inflows to be in the form of 1) FX purchase auctions; 2) reducing the lower bound of the interest rate corridor to gain flexibility to ease monetary policy; 3) RRR hikes or at least a stable RRR level. H

owever, we think the CBT will not be in a hurry to switch to the aforementioned alternative scenario, since it seems content with some further appreciation of the TRL and would probably like to be sure about the permanency of capital inflows. Moreover, the pace of loan growth will be of utmost significance concerning this decision. The CBT has been indicating that annualised loan growth rate (FX-adjusted) at around 15% is reasonable for the inflation target. Therefore, the CBT will continue to observe whether the recent trend is in line with the explicit target and react accordingly.

When we look at the recent loan figures, interestingly we see divergent trends in consumer loans and total loans. According to weekly loan data from the BRSA, FX-adjusted (fixed rate, fixed parity) yoy growth is similar to the previous year-end (23-24%) and trend-growth (annualised 13-week average) of FX-adjusted loans still remains in the range of (10-12%) as of February 3. However, the trend indicator for consumer loans that the CBT is following (annualised four-week moving averages) stands at 2%, significantly below the related figures for 2011 and for the average of the 2006-2010 period. We attach greater significance to the trend in total loans, and low consumer loan growth does not seem disconcerting to us, since it is supportive for re-balancing of domestic and external demand. Therefore, we think the recent trend is in line with the explicit target. This implies an unchanged monetary stance and funding cost for the time being.

However, three scenarios are possible for the near future: 1) If loan growth remains roughly around 15% -- as it has recently -- the CBT will maintain the funding cost at its recent level (7.5%), but seriously consider launching FX purchase auctions in case of appreciation pressure on the TRL due to capital inflows. 2) If loan growth dips clearly below 15%, the CBT might adjust the parameters (lower and upper limits for the amount of 1-week and 1-month repo) of the interest rate corridor to ease the funding cost to below 7.5%. 3) Conversely, if loan growth climbs significantly above 15%, the CBT will maintain higher funding costs and even consider higher RRR.

As we review the economic outlook that sets a backdrop to the expected developments in monetary policy discussed above, the most crucial piece of fresh news seems to be the estimate-topping industrial production (IP) reading as of Dec’11. We expect the comparative heftiness of the YE11 IP level -- hence the level at which it starts the new year -- to induce upward revisions to 2012 growth estimates. Investors will recall that industrial production rose by 3.7% yoy in Dec’11, exceeding market consensus of 2.3%. More importantly, seasonally-adjusted (SA) IP jumped to a record-high 131.5 in Dec’11, 8% above the pre-crisis peak in 2008. Since the original series of the IP tend to be more volatile and sometimes misleading, we opt to use IP (SA) figures to construct different scenarios for economic activity. Although there are differences between the two series in mom comparisons, the results should be the same in yoy comparisons. Therefore, barring a permanent break in IP (SA) series, the current stronger path suggests enduring growth in IP, the most important leading indicator of GDP. That is why we flagged a probable revision to our GDP growth forecast towards 3.5-4% from 2.5%, immediately after the data announcement.
Consequently, we revised our 2012 GDP forecast to 4.0%, as part of our base scenario envisaging around 2.5% sequential contraction in IP (SA) for 1Q12, to be followed by c.3.5% recovery until the year-end.

We also present here our two alternative scenarios, in order to show what could lead us to make new revisions. 1) Bad case: Around 4.5% sequential contraction in IP (SA) in 1Q12, to be followed by around 2.8% recovery until the year-end – consistent with around 2.5% yoy GDP growth in 2012; 2) Good case: Around 2.5% sequential contraction in IP (SA) in 1Q12, to be followed by around 6% recovery until the year-end – consistent with around 5% yoy GDP growth in 2012. We also need to underline the fact that upward revisions to Eurozone growth in particular or global growth -- as has already been the case recently by some global investment banks -- would be supportive of our above-consensus GDP forecast -- and even our good case scenario.

Accordingly, we have tweaked our other macro forecasts in line with changes in our GDP forecasts. Additionally, it is worth underscoring that recent data point to growth that is driven more by investment and external demand than consumption demand. For example, while 4Q11 import quantity index contracted by 1.8% with respect to the same quarter a year ago, export quantity index expanded by 5.8%. Leading export readings (Turkish Exporters’ Assembly (TIM)) as of the early months of the year and leading indicators of consumption (automotive sales and CNBC-e consumption index) also seem to suggest a continuation of this trend. While we consider this new composition to be healthier and more constructive for the sustainability of growth, we also believe it should help accelerate a balancing of internal and external demand.

In conclusion, the CBT is once again likely to indicate that a tighter monetary stance remains warranted for some time and it will continue to respond to potential shocks with the interest rate corridor policy. Additionally, the monetary authority may emphasize that in the event that it becomes more confident of the sustainability of strong capital inflows, which have been evident as of the start of the year, it might initiate steps to enable FX reserve accumulation, such as scaling up of the permissible amount of TRL RR kept in FX, and launching FX purchase auctions. As for the direction of the funding cost that has long been hovering at around 7.5%: it will continue to hinge primarily on loan growth, and to a lesser degree on signals from economic activity and inflation.

“Let's Do The Things We Normally Do”

The first Monetary Policy Committee (MPC) meeting of the year will be held on Tuesday, January 24. The fact that exactly a week later the first Inflation Report of the year will be issued, makes this meeting all the more significant: the brief statement to follow the meeting will provide initial clues as to the type of monetary policy to be pursued by the Bank within 2012.

Investors will recall that in the waning days of last year, faced with the TRL hitting a low of 2.20 against the currency basket and year-end inflation set to reach double-digit levels, the CBT implemented a mode of tightening it termed “additional monetary tightening”. This was implemented mainly via open market operations, and the liquidity funded to the market at the policy rate was reduced temporarily below the lower bound announced for “normal” days, and was even halted for several days. Moreover, unsterilised foreign exchange sales and interventions were used as a complementary instrument. The CBT also defined the main characteristic of additional monetary tightening as follows: “It is intended to be temporary and the duration of the implementation may vary depending on the speed at which the main factors affecting inflation outlook turn favourable." Indeed, with the TRL -- a factor of paramount significance for inflation -- having started to appreciate visibly since then, the CBT loosened its grip by injecting liquidity at the policy rate after an 8-day pause. During the course of this implementation, the blended cost of funding shot up some days to 12%, resulting in an average of 10.5%. The average of the 1-month period preceding this tightening, on the other hand, was a tad below 8%. Recently, the cost of funding has reverted to the interest rate range envisaged for “normal” days by the Bank (“During the course of this period, O/N rates in the interbank will be aimed to remain within a band of 8-12%, and the weighted average of banks’ funding from the CBT at 5.75-8.50%.”)

Consequently, given the comparative success of the additional tightening, markets will try to gauge first and foremost the following from the CBT’s statement: for how long the Bank will continue to effectively utilise the interest rate corridor policy, which has allowed it substantial flexibility in monetary policy manoeuvres. While we stated earlier that we deemed this strategy creative and effective, we nevertheless recognize that the flexibility it provided to the Bank on the flip side meant uncertainty for market players. Given frequent changes in the rules of the game, the direction and amount of change in the cost of funding from today until tomorrow are far from predictable. This, in turn, continues to lead to an elevated risk premium associated with the policy implementation in all types of pricing. We have observed that the Bank, aware of this inconvenience, has started to share information with the market as to its potential responses -- such as the lower limit applied to funding at the policy rate -- in a bid to enhance predictability. However, sudden shifts in monetary policy driven by frequent changes in market conditions have prevented this constructive approach from being appreciated by market players, leading it to be perceived more as a policy swing. As far as communication policy is concerned, we hope that the CBT has drawn the necessary lesson from this phase.

In the first Inflation Report of 2012, we reckon the CBT will most likely reiterate its claim that the year-end target will be attained, predicating its argument on the tightening implemented in the final quarter of last year and the recent additional tightening. In this case, it seems rather likely that the monetary authority will refrain from pronouncing a probable interest rate path or the direction of the monetary policy (tightening/loosening) in its base scenario for the rest of the year. These will likely be provided in the framework of alternative scenarios, based on different eventualities in terms of global risk factors.

As such, the Bank will probably be inclined to maintain the interest rate corridor policy so long as market conditions permit. Furthermore, as interest rate decisions have to be made at the MPC, it will likely have to provide its guidance as to the ranges within which it targets funding costs to fluctuate. Based on our calculations, since October 20, the date of inception of the corridor policy, the average cost of funding is around 7.75%, while the Bank has opted to keep the cost of funding at 7.50%-8.00% excluding “exceptional” days. It is also worth underlining that during the investor meetings held in Ankara, the Bank expressed its view that 12% was an excessive rate in terms of economic balances (Brazil’s 11% policy rate is the highest on a global scale, followed by India with 8.5%), while noting that it deemed reasonable the 5.75 - 8.50% range it foresaw for December. (*)

As we have mentioned before, we see this experiment as a test drive to determine the equilibrium interest rate at which money demand is equal to money supply. We still think that as long as the average cost of funding of CBT facilities (1-week repo, primary dealers facility and O/N Lending) remains significantly above the policy rate, the odds for the policy rate (5.75%) getting closer to the CBT’s blended rate would be higher. This implies scope, when needed, for policy rate hikes to the tune of 200bp, which are likely to be front-loaded under these circumstances. However, the CBT still seems content with this policy and is unlikely to change its stance in the near future.

On the other hand, a rise in the cost of funding and the general interest rate above current levels does not seem justifiable at this stage, given i) the retracement in trend consumer loan growth towards 10% at the end of last year is sustained in the initial weeks of 2012 as well; ii) the 5% appreciation of the TRL; and iii) signs of a strengthening in rebalancing of domestic and external demand. Moreover, potential surprises in the short term in industrial production and inflation might reinforce this perception. Based on our preliminary estimates, a slight negative (first signal being a 7% contraction in automotive manufacturing in December) or a minor positive annual industrial production growth figure seems of significant likelihood. As for inflation, the easing in core inflation on an annual basis -- for the first time since November 2010 -- might be solidified by a stronger TRL, though this may not be the case for headline inflation, which looks set to remain elevated in the early months of the year due to the base effect.

In conclusion, at the upcoming first MPC meeting of the year, the CBT is likely to convey its view that the prevailing tightness level is adequate. The monetary authority is also likely to indicate that it will continue to respond to potential shocks with the interest rate corridor policy. In the coming period, the degree to which the cost of funding will undershoot the average (8%) of the monetary tightening phase, will hinge on the extent of TRL appreciation. A firming of the TRL in tandem with an increase in global risk appetite would strengthen the CBT’s hand in its bid to reduce the funding cost. In the event of stronger-than-expected capital flows, the CBT may also mull halting the FX sale auctions. In the opposite case, on the other hand, the cost of funding level would largely hinge on signals from loan growth, economic activity, and inflation.

(*) The CBT pursues different strategies in “normal” and “exceptional” days.
- In “normal” days, the CBT will continue to hold regular 1-week repo auctions at 5.75%, at an amount of TRL3bn-7bn, and the blended CBT funding cost (as a result of 1-week repo (5.75%)), O/N lending rate to PD (12%) and 1-month repo (yield to be determined through competitive bidding) will be sustained within an interval of 5.75-8.50%. Moreover, the CBT will sell US$50mn via daily FX sale auctions.
- In “exceptional” days, the CBT will discontinue regular 1-week repo auctions at 5.75%. Instead, it will hold intraday 1-week repo auctions through competitive bidding; i.e. the yield will be determined at the auction. Moreover, the sale amount will be higher than US$50mn at the daily FX sale auction, and the CBT might intervene directly in the FX market.