Central bank facing new challenges

Consumer prices published yesterday indicate a rise in the momentum of inflation. Annualized inflation increased from 7.75 in January to 7.9 percent in February; this may be considered quite moderate, but we have observed dangerous increases in the core inflation indicators (H and I indices).
Indeed, in February, the H inflation index increased from 7.7 to 8.6 percent and the I increased from 7.6 to 8.4 percent on a yearl basis. These results are clear signs of increasing inflation in the coming months. In its last quarterly report on inflation, the Central Bank of Turkey was already obliged to increase its year-end inflation forecast from 6.2 percent to 6.8 percent. A second revision is now unavoidable. We will know the new forecast in April, when the second inflation report will be published. But we can almost be sure that the new forecast will be over 7 percent. Inflation is not getting closer to its target of 5 percent; on the contrary, it is moving away from it. One can say that this is not a new thing since this has been the case for years. The central bank will, once again, have to write a letter to the government, as the law requires, explaining that the culprit for increased inflation is the depreciation of the Turkish lira. I am not sure that the rise in inflation is that simple and won't affect our lives. Repeated failures concerning inflation put the credibility of the central bank at stake. Furthermore, open political pressure on the central bank's management, exerted by Prime Minister Recep Tayyip Erdoğan himself and by some other ministers criticizing interest rate increases, have established an unhealthy environment. The central bank cannot escape from its main duty: price stability. In Turkey, this means lowering the inflation rate close to the targeted 5 percent and keeping it there until a new target is set. Notes from the Monetary Policy Committee (PPK) extraordinary meeting of Jan. 28 indicate that this reality was clearly brought up: “In order to contain the deterioration in inflation expectations and pricing behavior, the committee implemented strong and frontloaded monetary tightening. … A tight monetary policy stance will be maintained until there is significant improvement in the inflation outlook.” Well said! However, there is a problem. Paradoxically, this tightening occurs in the context of low economic growth. Usually, monetary tightening is implemented when demand exceeds potential growth, in other words, when the economy grows too much that it leads to an increase in prices. Now, in our case, inflation is actually rising because of rising import prices due to the recent depreciation of the Turkish lira and, to some extent, because of the rise in food prices. One can claim that the depreciation is pushing inflation up, but this is a transitory effect and if the exchange rate is stabilized and the tight monetary policy is maintained, the rise in inflation would be reversed within a few months. That is true. The exchange rate seems to be stabilized, at least for this moment, but at a rather high level. This is good news for export-led growth. We may expect a positive contribution of net exports (exports growing more rapidly than imports). Nevertheless, it is not sure that the positive contribution of net exports would be sufficient to compensate an eventual decline in domestic demand. All leading indicators in this respect are in the red. The central bank's management is aware of this eventuality. One can read in the committee's meeting notes: “There is a gradual slowdown in loan growth stemming from the tight monetary policy stance, the recent macro-prudential measures and weak capital flows. The data regarding the first quarter of 2014 indicate some deceleration in final domestic demand.” I believe pursuing tight monetary policy in the context of low economic growth would not be an easy task at all for the central bank. The Justice and Development Party (AKP) government will test its popularity very soon -- in local elections on March 30. If the results from the ballot boxes are not satisfying for AKP rulers, they will be all the more worried for the presidential and general elections to follow, since the low economic growth will become more apparent and its adverse consequences on the social front will be felt even more. Given the approach of Erdoğan and his inner circle to the monetary policy, we can easily predict that they will not accept being simple spectators who simply wonder what the central bank is going to do. Frankly speaking, I am worried about the central bank in terms of the political pressures it will be facing in the near future.