Central bank still too optimistic

I have been impatiently waiting to see what the central bank would say in its July inflation report published on Thursday about its new inflation forecast, and particularly on the drift of the lira which we are currently witnessing.

If I have to give my quick impression, I would say our central bank is still in its usual optimistic mood that has never been justified in the last few years.

The tradition is that the central bank announces a year-end inflation forecast quite close to the target of 5 percent in its first inflation report published each January. Then it makes an upward revision in April, followed by a third revision, still an upward one, in July and so on. At the end of the year, the inflation rate unfortunately reaches a level over 7 percent, obliging the central bank, along with the existing rule, to write a letter to the government explaining the reasons for the failure. It is worth noting that these reasons always involve external shocks like a greater-than-expected depreciation of the lira or an out-of-control increase in food prices.

The tradition was followed this year as well. We started with year-end inflation forecasted at 5.5 percent, which was revised up to 6.8 percent in April. For the July revision, I was expecting a new forecast slightly over 7 percent but the central bank stood at just 6.9 percent, contenting itself with just a 0.1 percent increase. The annual inflation rate at the end of June being 7.2 percent, the central bank expects inflation to fall slightly. If inflation stands just under 7 percent, the central bank governor will not be obliged to write the usual letter to the government. Let me note that Governor Erdem Başçı underlined in his presentation that inflation must be kept under 7 percent. Let me also add that the forecast for 2016 has been maintained at 5.5 percent in line with tradition.

The central bank's calculations for this year might be summarized as follows: Falling food prices thanks to better weather conditions would contribute 0.3 percentage points and energy prices 0.1 percentage points. Nevertheless, the central bank admits the greater-than-expected depreciation of the lira has adversely affected its inflation forecast by 0.5 percentage points. This is a critical point regarding the inflation dynamic. Because of ongoing political uncertainties -- the likelihood of an early election is now almost 100 percent -- the drift of the lira continues. The overall depreciation of the lira against the dollar and the euro reached 3.5 percent in the last few days. Adding the expected monetary policy move by the US Fed in a few months and the turmoil derived by a new electoral campaign that will be harsher than the previous one, we should expect a greater depreciation of the lira, all the more since the central bank does not seem ready to react.

Indeed, the central bank appreciates that the actual monetary policy is tight enough and does not need to be changed to curb the high inflation. The inflation report estimates that the expected real interest rate considering the market interest rate of two-year Treasury bonds and the expected inflation for the same term is close to 3 percent, which is slightly higher than the expected real rates in most emerging markets. It is worth noting the increase in market interest rates combined with inflation expectations that are rather under control pushed up the Turkish real interest rate at some extent in the recent past. That said, it is uncertain if inflation expectations might be kept under control in the near future given the existing risks. One may argue the central bank can intervene in the currency market by increasing its actual sales of $40 million per day. However, do not forget that currency reserves of around $120 billion are not considered comfortable when facing the risk of capital outflows. A recent Commerzbank report shows that Turkey is among the most fragile economies in the event of a Sudden Stop.

I hope the central bank is right in refusing to consider further tightening of its monetary policy but my experience and intuition tell me it is still too optimistic.