Fears of inflation

January inflation indexes have been anxiously awaited. The critical question about the inflation is the the impact of the recent exchange rate shock on local prices through import price increases, the so-called “pass-through” effect. This effect is critical because it may push up inflation and with it inflation expectations. Such a push would obligate the central bank to overhaul its new inflation forecast -- set at 6.6 percent -- upwards and, in this case, its policy interest rate -- currently at 10 percent -- must also be overhauled upward. Given the current political debate on the monetary policy that prevents the central bank from using its interest rate as a weapon freely, properly and timely, a drift in inflation would further increase the uncertainties and complicate more the way out.
Unfortunately, the January inflation figures confirmed the existing concerns. At first glance, the rise of the head inflation, the Consumer Price Index (CPI), has been rather limited. It rose from 7.4 percent to 7.5 percent on the yearly basis. However, core inflation has been pushed up by 0.6 percent, reaching 7.6 percent. Moreover, the monthly increase has been much stronger at 1.7 percent. One quarter of the central bank's 2014 inflation forecast has already been exhausted. Otherwise, during the remaining 11 months, the average inflation increase must not exceed 0.5 percentage points per month if the 6.6 percent forecast, perceived as an implicit inflation target by the economic players, is to be taken seriously. Is such a fortunate event possible? If we consider the possible effect of the exchange rate shock on the CPI, we can hardly be optimistic. Indeed, the new Domestic Producers' Price Index (DPPI), excluding agricultural prices and limited to industrial prices, made an impressive jump in January, increasing by 3.3 percent from December. The annual increase of the DPPI reached 10.7 percent. The impact of the pass-through is obvious. We know that this jump in cost inflation will also push the CPI up in the coming months. Furthermore, the bad news is that the whole pass-through effect has not fully shown up yet. If the exchange rate does not decrease sizably in the coming days, producers' prices will continue to increase strongly in February and the CPI will also increase along with in the coming months. Currently, we do not see any signs in this respect. The exchange rate between the US dollar and the Turkish lira seems to have been anchored around 2.26 since the interest rate reaction of the central bank last week. Admittedly, this reaction prevented a drift in the lira, but it has been revealed as insufficient to give the expected strength to it. It has become obvious that the central bank cannot overcome the difficulties alone. An additional increase in the central bank's policy rate might be envisaged but such a decision seems very difficult politically, and even if it happens, it is not certain that it would be able to attract demand for lira-denominated assets again. So, what can we hope for? Well, politics must intervene. A few days ago Prime Minister Recep Tayyip Erdoğan spoke about plans "B" and "C." We do not yet exactly know their content. However, considering the rumors, I do not believe that those plans contain convincing items able to encourage capital inflows, except for a massive offer of Treasury bonds by the Treasury. These bonds being, of course, kept in a public found and thus not spent, would push the market interest rate up and may encourage portfolio investments, opening the way for an appreciation of the lira. If not, the only remaining way to help the central bank would be a political step forward regarding the reorganization of the judiciary and of the so-called democratization package about to be announced by the government. We desperately need a compromise between the incumbent and main opposition parties on reshaping the Supreme Board of Judges and Prosecutors (HSYK) on a radical reform of the Turkish Penal Code (TCK), as well as on basic reforms regarding the settlement process. Only a compromise on these hot topics can dissipate political uncertainties and may allow the return of confidence with respect to political stability. If a path to compromise is not forged quite soon, I'm afraid the economic situation might get worse.