Looking for the right policy mix

The “hot debate” about low economic growth that I was talking about in this column two weeks ago (“Second quarter confirmed worries about low growth”) is wide open.
From now on, all protagonists of the debate admit the unpleasant reality of low growth. Central Bank of Turkey Governor Erdem Başçı forecasts 3-4 percent growth for this year. I agree in broad terms, but I should note that the final result could be worse. So the critical question today is how to give a push to domestic demand, which is on a decreasing path, without jeopardizing the rebalancing process of the national economy. I must say that this is not an easy task and falls on the shoulders of, quite naturally, the central bank and the government. What can be done regarding monetary policy and fiscal policy? How could the policy mix, the combination of monetary and fiscal policies, be organized in order to push up growth without endangering the decreasing trend of the current account deficit (CAD) as well as that of inflation? The first responses from the central bank and the government to these questions came last week. In brief, monetary policy will be cautiously relaxed if necessary, while fiscal policy will continue to be kept tight. Is it the right policy mix? Let’s see. Two weeks ago I wrote that while I recognize the serious risk in abandoning the rebalancing process too early, I keep my optimism, given my hope to see the Turkish troika -- Deputy Prime Minister Ali Babacan, Minister of Finance Mehmet Şimşek and Governor Başçı -- prioritizing the rebalancing process, and that they will be able to convince Prime Minister Recep Tayyip Erdoğan of this stance. I have not been disappointed, at least for the moment. Indeed, important decisions that have been taken as well as stands made last week confirm my optimism. Regarding monetary policy, last week’s Monetary Policy Committee (PPK) of the central bank did not change its policy interest rate, keeping it at 5.75 percent, and contented itself with lowering the upper limit of its overnight interest rate corridor by only 1.5 percentage points. For the non-experts, let me explain that this move does not mean a loosening of monetary policy; it is just a signal of possible loosening in the future, if necessary. In fact, the daily interest rate (cost of liquidity for banks) asked by the central bank has for months been well below the upper limit of the corridor, which was set at 11.5 percent and is now lowered to 10 percent. The bank still has enough room to make the cost of money available in the market higher. Along with this decision, the statement of Governor Başçı in his conference with the business community of Kocaeli province must be considered in this context. Responding in a way to Economy Minister Zafer Çağlayan -- who previously said, following the disappointing growth rate of the second quarter, that “the brakes have started to burn” -- Mr. Başçı declared that “the brakes are being smoothly released. Otherwise the domestic demand could increase tremendously, causing in turn an increase of the CAD.” He also added that “domestic demand will be encouraged only within the limits of export increases.” Again, all this can seem quite complicated, but let me make it clear that Mr. Başçı is simply saying that monetary policy will be loosened cautiously as long as rebalancing process is not endangered. On the fiscal policy front, the same firm attitude is observed. This year’s budget deficit, counting on a growth rate of 4 percent, has been set at 1.5 percent of gross domestic product (GDP). But by the end of August it became obvious that the deficit would be larger, for two main reasons. First, growth is lower than what has been predicted, and this decreases planned tax revenue. Second, the expenditures are higher than planned because public employees’ salaries have been increased more than planned, as well as social transfers. During a conference in London last week, Mr. Babacan announced that the deficit would reach 2.5 percent of GDP instead of 1.5 percent. He has not specified if he includes in his forecast both of these two adverse effects, but I think that he took into account only the effect of low growth on tax revenue. Indeed, on Saturday, while the country was in its weekend torpor, the Ministry of Finance announced tax increases on fuel and alcoholic beverages. Anyway, this is only the first wave, and other tax increases will follow for sure. Otherwise the deficit would be higher than the fateful 3 percent threshold. To sum up, two points have to be noted: First, the central bank will not lower its policy rate, except in the case of huge hot money inflows capable of appreciating Turkish lira. Mr. Başçı remarked during the conference mentioned above that the value of the national currency is actually at the right level. So his bank will do nothing to discourage exports. Second, indirect tax increases are bad news for inflation, and once again Başçı noted that we are still far from the inflation target of 5 percent. This means that the bank is ready to compensate for inflation pressures originating from indirect tax increases if necessary; too bad for domestic demand. Given these dilemmas -- we economists call them “tradeoffs” -- and given the puzzling delay of low growth’s impact on unemployment, which is still stagnating, I think the decisive battle of low growth through economic policies has not yet started and that what we are witnessing at the moment are only skirmishes.