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.

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.