Monetary policy debate is over for a while

Last Saturday in my piece “The prime minister is not convinced,” I asked “What will the next episode look like with the profound disagreement over monetary policy?” I said in response: “The first critical revelation will be the publication of the [gross domestic product] GDP figures for the first quarter on June 10. If the growth rate is well below 4 percent, one can expect a harsh reaction from the prime minister.”

Well, we received the figures on Tuesday. GDP growth for the first quarter reached 4.3 percent on an annual basis, surpassing expectations. Indeed, Deputy Prime Minister Ali Babacan and Turkish Central Bank Governor Erdem Başçı recently declared that the growth rate would be close to 4 percent but below. Similarly, our last forecast at the Bahçeşehir University Center for Economic and Social Research (BETAM) was 3.7 percent.

Prime Minister Recep Tayyip Erdoğan stated the same day that this growth performance was achieved thanks to the confidence shown in the government by businessmen, workers, farmers, etc. despite the “attempts at destabilization.” The prime minister seems to be quite happy with the growth performance even though it is not as high as he desires. Thus we may expect a break in the monetary policy debate since economic growth of over 4 percent allows unemployment to fall slightly and public expenditures to increase modestly without jeopardizing fiscal discipline. Moreover, growth in the first quarter being led mostly by exports as I detail below reduced the current account deficit (CAD) to some extent. Finally, the balanced growth claimed by the Treasury and the central bank is under way, at least for the moment.

How did GDP growth outperform forecasts? The explanation is not too complicated: The increase in exports was much higher than expected. The analysis of demand items from quarter to quarter (see BETAM's research brief “Türkiye ekonomisi dış talep ile büyüdü” [Turkish economy grew with external demand] published on June 10) shows that both private consumption and investment decreased in the first quarter compared to the last quarter of 2013; the former by 0.5 percent and the latter by 2.8.

There is no surprise with regard to domestic demand. The exchange rate shock (the rapid and sizable depreciation of the lira) followed by an interest rate shock caused the expected adverse effects on consumer durables and investment. Two items saved growth in the first quarter: net exports and public spending. Exports increased by 7 percent while imports fell by 2.4 percent. Thus net exports contributed 2.6 percentage points to quarterly growth that reached 1.7 percent. Let me note that the growth rate from the third quarter of 2013 to the fourth quarter was limited to 0.9 percent. The second item that accelerated GDP growth in the first quarter was public expenditures, which grew by 4.8 percent, contributing 0.8 percentage points to growth.

There are now two critical questions regarding monetary policy. First, how will the central bank react to this growth performance? Second, will economic growth continue to perform as it did in the first quarter? No doubt, the growth performance in the first quarter has reduced the political pressure exerted on the central bank. This will allow the central bank's Monetary Policy Committee (PPK) to limit its expected interest rate decrease at its next meeting on June 24. On the other hand, the recent monetary loosening measures taken by the European Central Bank gave the Central Bank of Turkey additional room for an interest rate decrease without provoking an exchange rate shock. Thus, we may expect a relatively sizable but not adventurous reduction in the policy rate, actually at 9.5 percent. Personally, I would agree with a drop of 0.75 percentage points.

As for the future of economic growth, we may be moderately optimistic. According to leading indicators, an increase in both private consumption and investment is perceptible in the second quarter since the lira recovered from most of its losses and market interest rates have been relaxed to some extent. European recovery is ongoing, which is good news for Turkish exports. The revival of domestic demand will increase imports but we can still forecast a positive contribution of net exports to growth, albeit to a lower degree.

However, one must note the appearance of a last-minute risk on this front. Mosul, where an oil pipeline transports Arab as well as Kurdish oil to Turkey, has fallen under the control of radical Islamists fighters. Turkey's second-largest export market after Germany is now under threat. With the exception of this new risk, I believe a growth rate of around 4 percent this year seems reasonably attainable. This may be sufficient to calm Mr. Erdoğan down.