Meeting with economy officials

Fiscal discipline plus flexible monetary policy Last Friday Deputy Prime Minister Ali Babacan invited some economic commentators to a working lunch. I was among the participants. Babacan was accompanied by the governor of the Central Bank of Turkey, Erdem Başçı, and Treasury Undersecretary İbrahim Çanakçı, who made very instructive presentations followed by question-and-answer sessions that were even more instructive.
I left the lunch feeling that what I have been arguing in this column for a while had been confirmed: The Turkish economy is doing rather well, but still faces serious challenges. Başçı seems quite confident in the new monetary approach the central bank implemented almost two years ago, which is still, nonetheless, under severe criticism. This new approach consists of the implementation of new instruments besides the central bank's interest rate policy, and aims to tackle a standard dilemma: How can inflation be curbed without overvaluing the local currency? Fighting inflation requires control of aggregate demand through high real interest rates, which can be induced by raising the policy rate. At the same time, rapid appreciation of the local currency provoked by the massive inflows of capital that high interest rates attract must be avoided if one doesn't want to widen the current account deficit. From the beginning I supported the new monetary approach not because I am an expert in monetary policy but simply because I know one of the rules of thumb of economics well: If you have two goals to achieve, you have to use two instruments. Başçı recalled the standard dilemma and the necessity of using alternative instruments, like the interest corridor, which makes interest rate policy more flexible; and the reserve option mechanism, which stabilizes the exchange rate. Macroprudential measures aiming to control credit expansion, which are under the aegis of the Banking Regulation and Supervision Agency (BDDK) are added to this panoply. It is worth noting at this point the sentiments of Babacan, who underlined the importance of regular meetings of the Financial Stability Committee, which is in charge of coordinating macroprudential measures. The fitness of all economic policies, of course, must be tested by their results. Well, the results seem to be rather convincing. Turkey's exchange rate volatility became the lowest among emerging markets in recent months despite the turmoil caused by the US Federal Reserve's announcements of a possible tightening of monetary policy. Başçı continues to think that the Turkish lira is actually slightly undervalued, so there is room for limited appreciation without jeopardizing the current account deficit, and disinflation is under way thanks to tighter interest rate policy. Furthermore, Başçı underlined the return of long-term US Treasury bonds' real interest rates to positive, around 1 percent -- a level higher than Fed Chairman Ben Bernanke desired. This means that in the near future massive capital outflows should not be expected; hence, there is no need to further increase interest rates. The central bank's reserves, which are growing once again, should be sufficient to avoid exchange-rate shocks. Of course, one cannot yet claim definitive success for the new monetary approach, but I believe that it has already passed its midterm exam. As for fiscal policy, there is no hesitation: Turkey is among the best performers regarding budget deficit. Çanakçı estimates this year's budget deficit-to-GDP ratio at 1.5 percent, well below the target. The public debt-to-GDP ratio will continue to fall; by the end of 2016 it is expected to be around 30 percent. A colleague asked Babacan if the government would relax fiscal discipline ahead of upcoming elections. While Babacan was trying to convince this colleague that the Justice and Development Party (AK Party) government had never set aside fiscal discipline in any electoral season, I intervened, saying, “Don't worry, we can criticize Mr. [Prime Minister Recep Tayyip] Erdoğan on many economic issues, but one thing is certain: He believes firmly in fiscal discipline.” I have no more space in this column to talk about the challenges facing the economy. However, I would like to add that my comments during the debate were particularly focused on the lack of political will for economic reforms, and I gave as an example the abandoning of severance pay reform. I had written in this column that since Erdoğan says that all parties involved must compromise on the reform project, my bet would be against compromise and thus against reform. Unfortunately, I won the bet.