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.

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.

Where I agree and disagree with Babacan

No way out without reforms Last Monday, in an interview on TV, Deputy Prime Minister Ali Babacan made some important assessments of the hot issues that Turkey is trying to handle.These assessments are worth discussing since they are rather realistic and not pure political propaganda. I saw five major topics in Babacan's assessments: the policies of the Central Bank of Turkey, the state of unemployment and its future in terms of economic growth, the sustainability of the current account deficit (CAD) and, finally, the need for reforms.
Minister Babacan started by saying there is no crisis; thus there is no need for a comprehensive economic package. So we can now stop fretting ourselves by trying to guess what kind of measures may come with the famous “Plan B and Plan C” announced by Prime Minister Recep Tayyip Erdoğan just after the central bank decided to increase interest rates. Erdoğan said last month that an "out of the ordinary" economic package alternative to interest rate hikes could be announced. He added that work on a Plan B or Plan C may be announced in the coming days or weeks. We have heard nothing but rumors circulating about these mysterious alternative plans so far. Regarding monetary policy, Babacan reiterated his support for the unconventional policies of the central bank. He argued that the interest rate corridor instrument (multiple and varying interest rates) had prevented inflows of large quantities of short-term capital. As a result, he said, the impact of the US Federal Reserve's policy and the Dec. 17 corruption scandal on outflows had been mitigated, since there was no great quantity of hot money in Turkey. I agree. This point is often missed in the debate about the central bank's monetary policy. That said, I do not agree with Mr. Babacan when he says that the central bank was not wrong in delaying its interest rate decision. Indeed, the Monetary Policy Committee (MPK) refused to move on the issue during its meeting in January, but it was obliged to increase interest rates a few days later in an extraordinary meeting because investors had started to sell their Turkish Lira denominated assets in a panic, causing a dangerous shift in the exchange rate. Mr. Babacan argued that this panic was due to the serious turmoil that had occurred in Argentina and Russia two or three days after the MPK's meeting. This argument is hardly convincing. Personally, I think the political pressure on the central bank was so stifling that the MPK was not courageous enough to increase interest rates earlier, hoping that this omission would not affect investors' behavior. It was a great mistake. However, I fully agree with Babacan's assessment of the evolution of unemployment. He was right in pointing out that the rate of unemployment had been on an upward path, but that during the last two months of 2013 it leveled off. He added, “It is too early to make a comment, but if we see our growth in gross domestic product [GDP] below 4 percent, then the jobless rates could be relatively higher.” So the critical issue is expected growth this year. On this point, the deputy prime minister was rather cautious. After saying that growth performance will depend both on domestic demand and exports, he indicated that it is still too early to make a projection on domestic demand, but expectations on exports to the EU market are promising. Unlike Mr. Babacan, I am almost certain that domestic demand, particularly demand for investment and durable consumer goods in the first quarter, will be very weak. But Babacan is right to expect that there will be more exports to the EU. Last year, these exports grew for the first time since the eruption of the economic crisis. This year, the EU economy seems to be in better shape. So we can count on exports to the EU market. I wrote in a previous column that my growth-rate forecast for this year is around 2.5 percent. Since then, many other predictions have been published. Even the most optimistic ones do not predict a rate over 3 percent. If these turn out to be correct, the Justice and Development Party (AK Party) will be faced with increasing unemployment and stagnating well-being. The deputy prime minister is certainly aware of this challenge. As he pointed out, the Turkish economy is unable to have 4-5 percent growth without lowering its CAD to a sustainable level. Mr. Babacan thinks that this level might be 4-5 percent, but the deficit must be even lower in the long run. Let me point out that the CAD/GDP ratio is actually over 7 percent. Admittedly, the challenge is a difficult one. This may be the reason why Babacan insisted once again on economic reforms during his interview. The fact that he insisted on reforms shows great virtue in these days of political madness.

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.

I appreciate the efforts of Mr. Babacan, but...

Vice Prime Minister Ali Babacan at Davos I was not in Turkey last week, but it was still a very passionate one. I visited Cordoba and Granada, the two main centers of the Andalusia civilization during the period between the eighth and 15th centuries in what is now Spain. It was a civilization that succeeded not only in building very beautiful as well as sophisticated mosques and palaces, but also a multicultural society where Muslims, Jews and Christians enjoyed freedom of belief and contributed jointly to the progress of humanity. The decline of the Andalusia civilization began with a military coup that was perpetrated by the legendary commandant Al-Mansour, or Almanzor, against the last Umayyad caliph.
This coup opened the way for the “fitna” (internal fight in Arabic), and a civil war followed in 11th century. The political divisions in the country and the long-lasting political instability paved the way for the Reconquista, though it still took almost two centuries, beginning with the fall of Cordoba in 1236 and ending with the surrender of Granada in 1492. While I was admiring the legacy of the Andalusia civilization, my mind was on my country's economic turmoil that has deep political roots. In countries where independent economic institutions are not well established and the separation of the economy from the polity is not secured, political uncertainties may cause great damage to the economy. I think this is a shortcut explanation of what is happening nowadays in Turkey. In my recent columns I tried to explain why the Central Bank must react to the unending climb of the exchange rate through an increase in the interest rates. I was aware that the causes of this steady rise were mostly to be found in the current political crisis, but a reaction from the Central Bank was needed because the wait-and-see policy has been risking further deepening concerns with respect to its independence. Last Tuesday, the monetary policy committee (MPC) contented itself with a very timid reaction: It decided to sell money some days at 9 percent instead of 7.75 percent. This did not convince economic actors at all and the exchange rate breaks new records every day. When I came back from my short holiday, I got up to date on the events and comments that I had missed. What struck me the most was the efforts of Mr. Babacan, the deputy prime minister in charge of economic affairs, trying to convince an audience in Davos that the exchange rate shock is transitory, the EU anchor is solid, the adverse effects of Turkish firms' debts on their balance sheets are exaggerated and last, but not least, that the independence of the Central Bank is not at stake, despite the unfortunate statements of some ministers. So, here are Babacan's arguments in a nutshell and my brief comments. Babacan believes that the exchange rate shock is transitory since the shock did not have its origin in capital outflows, but was due to panicky purchases of hard currencies by Turkish firms that are indebted to “some extent.” The fact that foreign capital is not flying out is certainly good news, but not enough to conclude that the shock is transitory. If Turkish firms purchase US dollars at very high rates, this means that they expect further depreciation of the Turkish lira. The question is: How will these dangerous expectations be reversed? Mr. Babacan offers only some weak arguments. He claims that the “EU anchor is solid” and that the political uncertainties will soon dissipate. Yes, the EU anchor is in place for the moment, but no one can guarantee that this will be the case if the government insists in its ambitions to control the judiciary. As for political uncertainties, I believe that they will last at least until the local elections of March 30 and even after that date, I do not think that they will be easily dispersed. According to Mr. Babacan, the debts of Turkish firms denominated in hard currencies are not so dangerous. Indeed, he claims that owners of these firms have large deposits in foreign currencies enough to help repay their debts. Yes, but do not confuse the personal fortunes of Turkish capitalists with the value of their firms. They can easily choose to keep their fortune intact instead of providing their firms with equity. The most dramatic of Mr. Babacan's efforts has been the defense of the Central Bank's independence. He knows very well that Central Bank may be obliged to react much more aggressively if the depreciation of Turkish lira persists. The deputy prime minister sent clear warnings to other ministers who like to recommend what the Central Bank must or must not do, saying, “It is absolutely wrong to violate the independent sphere of the Central Bank.” I hope Mr. Babacan will be heard.

Awaiting the central bank's reaction

Taxi drivers are known as people with a good flair for economic speculation. We, the economists, make predictions based on reflections that combine economic theory and intuition, but we prefer to wait for the largest volume of statistics possible before risking a forecast. When the speed of economic events is rapid, waiting for the statistics becomes very painful, since, as an economist, you have to answer the standard, nasty question: How is the economy going? At those times, the flair of taxi drivers might be a great help.
On Thursday, when I hailed a taxi in front of my university, my driver recognized me thanks to my appearances on TV, and without losing a minute, he asked the famous nasty question. I answered “Not very well,” preferring to remain elusive. My driver reacted immediately, announcing vehemently, “The economy is going very badly.” “Why do you think so?” I asked. Because, he said, “My turnover has diminished by 40 percent since the new year,” adding that the current political crisis is so dangerous that it might lead to a civil war. “God forbid!” I said instinctively. “God forbids this in intelligent societies, not idiotic ones,” he responded. In fact, my taxi driver revealed not only an ambitious flair but also that he is a philosopher.   One hour later, when I was coming back to my office, I compared the flair of my first taxi driver with the new one. He confirmed to me that his taxi's turnover has effectively gone down. To be frank, I had been not thinking that the Turkish economy could be in such bad shape! In my last piece (“Exchange rate debate”) I argued that the duration of the Turkish lira's depreciation would be the determinant of economic growth. In other words, whether Turkey faces a recession or just slow growth will depend on the effects of the evolution of the exchange rate. Now, I think, thanks to the taxi drivers' flair as well as the evolution of the exchange rate since Monday, the risk of recession must be seriously considered. As of Friday, the dollar-Turkish lira parity exceeded 2.20, while it was around 2.17 a few days earlier. What happened in the meantime? Well, the crisis regarding the restructuring of the Supreme Board of Judges and Prosecutors (HSYK) through a new election system has deepened since the main opposition party, the Republican People's Party (CHP), refused the Justice and Development Party's (AK Party) proposal. Then the warnings coming from Europe about judicial independence became more vehement. European warnings must be considered seriously by the government, because they may result in a suspension of membership negotiations with the European Union if the incumbent party insists on its draft law to reorganize the HSYK.   Under these circumstances, the Turkish lira may continue to depreciate further. Even if it keeps its current value in the coming months, I am almost certain that a recession in the first quarter will be unavoidable, and if the political uncertainty is not dissipated, the slow growth that I predicted may become a recession for the whole year. Economic circles are now focused on the Monetary Policy Committee meeting to be held next Tuesday. As I already pointed out, the central bank cannot avoid reacting to this increase, i.e., by further tightening its monetary policy, since its credibility is already being questioned. I believe an interest rate increase has become unavoidable. Some commentators claim that an interest rate increase risks making the recession more probable. I do not agree. If the central bank's reaction is able to reverse the exchange rate and stabilize the USD-TL parity at around 2.10 at least, the damage caused to economic growth by higher interest rates will be less effective than the damage caused by an excessively depreciated Turkish lira. Indeed, in the worst-case scenario, investments and even private consumption risks being seriously affected. What might happen if an interest rate increase remains insufficient to reverse the pessimistic expectations and thus the exchange rate? This is a legitimate question, since the origin of the actual turmoil must be attributed mostly to the political crisis rather than economic factors. Probably an interest rate increase will not be a sufficient remedy, but it will announce, at least, that the central bank is not disoriented by the “interest rate lobby” discourse, and its independence is not in question. The best solution to the current threat is, of course, a compromise on the HSYK dispute between the incumbent party and the main opposition party, as President Abdullah Gül suggests. Nevertheless, if this compromise proves impossible, the central bank must move.

Meeting with economy officials

Fiscal discipline plus flexible monetary policy Last Friday Deputy Prime Minister Ali Babacan invited some economic commentators to a working lunch. I was among the participants. Babacan was accompanied by the governor of the Central Bank of Turkey, Erdem Başçı, and Treasury Undersecretary İbrahim Çanakçı, who made very instructive presentations followed by question-and-answer sessions that were even more instructive.
I left the lunch feeling that what I have been arguing in this column for a while had been confirmed: The Turkish economy is doing rather well, but still faces serious challenges. Başçı seems quite confident in the new monetary approach the central bank implemented almost two years ago, which is still, nonetheless, under severe criticism. This new approach consists of the implementation of new instruments besides the central bank's interest rate policy, and aims to tackle a standard dilemma: How can inflation be curbed without overvaluing the local currency? Fighting inflation requires control of aggregate demand through high real interest rates, which can be induced by raising the policy rate. At the same time, rapid appreciation of the local currency provoked by the massive inflows of capital that high interest rates attract must be avoided if one doesn't want to widen the current account deficit. From the beginning I supported the new monetary approach not because I am an expert in monetary policy but simply because I know one of the rules of thumb of economics well: If you have two goals to achieve, you have to use two instruments. Başçı recalled the standard dilemma and the necessity of using alternative instruments, like the interest corridor, which makes interest rate policy more flexible; and the reserve option mechanism, which stabilizes the exchange rate. Macroprudential measures aiming to control credit expansion, which are under the aegis of the Banking Regulation and Supervision Agency (BDDK) are added to this panoply. It is worth noting at this point the sentiments of Babacan, who underlined the importance of regular meetings of the Financial Stability Committee, which is in charge of coordinating macroprudential measures. The fitness of all economic policies, of course, must be tested by their results. Well, the results seem to be rather convincing. Turkey's exchange rate volatility became the lowest among emerging markets in recent months despite the turmoil caused by the US Federal Reserve's announcements of a possible tightening of monetary policy. Başçı continues to think that the Turkish lira is actually slightly undervalued, so there is room for limited appreciation without jeopardizing the current account deficit, and disinflation is under way thanks to tighter interest rate policy. Furthermore, Başçı underlined the return of long-term US Treasury bonds' real interest rates to positive, around 1 percent -- a level higher than Fed Chairman Ben Bernanke desired. This means that in the near future massive capital outflows should not be expected; hence, there is no need to further increase interest rates. The central bank's reserves, which are growing once again, should be sufficient to avoid exchange-rate shocks. Of course, one cannot yet claim definitive success for the new monetary approach, but I believe that it has already passed its midterm exam. As for fiscal policy, there is no hesitation: Turkey is among the best performers regarding budget deficit. Çanakçı estimates this year's budget deficit-to-GDP ratio at 1.5 percent, well below the target. The public debt-to-GDP ratio will continue to fall; by the end of 2016 it is expected to be around 30 percent. A colleague asked Babacan if the government would relax fiscal discipline ahead of upcoming elections. While Babacan was trying to convince this colleague that the Justice and Development Party (AK Party) government had never set aside fiscal discipline in any electoral season, I intervened, saying, “Don't worry, we can criticize Mr. [Prime Minister Recep Tayyip] Erdoğan on many economic issues, but one thing is certain: He believes firmly in fiscal discipline.” I have no more space in this column to talk about the challenges facing the economy. However, I would like to add that my comments during the debate were particularly focused on the lack of political will for economic reforms, and I gave as an example the abandoning of severance pay reform. I had written in this column that since Erdoğan says that all parties involved must compromise on the reform project, my bet would be against compromise and thus against reform. Unfortunately, I won the bet.

Relax until autumn

Wednesday morning, Deputy Prime Minister Ali Babacan gave an interview to a Turkish TV program and in the afternoon, US Federal Reserve (Fed) Chairman Ben Bernanke testified to the US Congress.
Bernanke seems successful in convincing markets Both of them tried to calm tensions that have appeared in the financial markets during the last weeks and to convince investors that, in fact, there was a terrible misunderstanding. Babacan, following the critical meeting at Dolmabahçe (see my article from Tuesday, July 15, “Plots out, common sense in”) that seems to have succeeded in convincing Prime Minister Recep Tayyip Erdoğan of the dangers of confronting market forces, clearly explained that for 10 years the Justice and Development Party (AK Party) government has played the game of an open market economy and it will continue to play the same game in the future. He also strongly reminded listeners that the central bank is an independent institution and thus free to set the monetary policy according to its mission. So, inside Turkey, tension declined to some extent, as evidenced by a slight appreciation of the Turkish lira and a buoying stock market. As for Bernanke, the stakes are even more important, since misunderstandings regarding the Fed's intentions are detrimental not only to the Turkish economy but for the world's economies. So, Bernanke's testimony to Congress aimed to clarify how the Fed evaluates the current situation of the US economy and more importantly, how it is setting benchmark conditions that will guide its monetary policy in the future. Let's start with Bernanke's mea culpa. The Fed chairman explained that at the June Federal Open Market Committee (FOMC) meeting, he and his colleagues anticipated real gross domestic product (GDP) growth beginning to increase during the second half of this year and eventually reaching 2.9, and 3.6 percent in 2015, and for the unemployment rate to decline to between 5.8 and 6.2 percent by the final quarter of 2015. Moreover, these forecasts have not been subject to external shocks like undesirable federal fiscal policy moves and the slowdown of economic growth in emerging markets. Bernanke specified that “in the interests of transparency, Committee participants agreed in June that it would be helpful to lay out more details about our thinking regarding the asset purchase program … as well as of the likely trajectory of the program if the economy evolves as projected.” Admittedly, markets had overreacted -- this is my interpretation -- to this desire for transparency. According to Bernanke, “With unemployment still high and declining only gradually and with inflation running below the Committee's long-run objective (2 percent), a highly accommodative monetary policy will remain appropriate for the foreseeable future.” First, the Fed will wait until it is sure of the strength of the ongoing recovery and when that is the case, it will start to reduce its asset purchasing. If the US economy has close to 6.5 percent unemployment and 2 percent inflation, the asset purchase program will be terminated as a tool of extraordinary times where the Fed policy interest rate is close to zero and cannot be turned into a negative rate. However, while this extraordinary tool will eventually be out of use, the Fed “… intends to maintain a high degree of monetary accommodation for a considerable time after the asset purchase program ends and the economic recovery strengthens.” This will be done by maintaining the federal funds rate at close to zero. In his testimony, Bernanke took care to add a new clarification regarding the guiding conditions of the monetary policy. He said, “The specific numbers for unemployment and inflation [6.5 percent and 2 percent] are thresholds, not triggers. Reaching one of the thresholds would not automatically result in an increase in the federal funds rate.” Then he explained that if, for example, unemployment reaches 6.5 percent, but not through a rise in employment but rather through a decline in the labor force, or if the unemployment threshold is reached, but not the threshold for inflation, the Fed will not be in a hurry to increase its federal funds rate. All those sophisticated and well-calibrated definitions and announcements are part of the difficult art of communication for central banks. One can assert that Chairman Bernanke gave a good example of this art form. I think that we can sleep soundly, at least until autumn. The risk of financial turbulence has been greatly minimized. Once autumn has passed, we will have to scrutinize very carefully the evolution of the US economy and track this evolution on the roadmap provided by Bernanke. In doing this, we cannot, of course, solve our structural problems, but we may at least avoid the surprises and the damage of high volatility in the markets.

It may be time for capital controls

We have started to witness extraordinary times in economic management. The Justice and Development Party (AK Party) government has succeeded in transforming an ordinary “sudden stop” event, very common in open market economies with high current account deficits (CAD), into an intentional plot against them. A witch hunt season has begun.
controlling capital flows Tuesday, the Banking Regulation and Supervision Agency (BDDK) decided to investigate foreign exchange deals in order to uncover alleged “manipulations” following the central bank auctioning of $1.3 billion in a single day. The BDDK wrote to banks asking for details of the auction bids and for what purpose they had bought foreign currency. Last month, while the Gezi Park protests and massive sales of assets in the İstanbul stock market were taking place, Turkey's Capital Markets Board (SPK) had launched an investigation into selling orders. Investors exiting Turkish markets and the lira selloff have essentially been caused by the US Federal Reserve (Fed) announcement that the quantitative easing -- in other words, the systematic purchase of assets from the financial market -- may be terminated in 2014 if the recovery of the US economy is still underway. Political tensions provoked by the Gezi Park protests certainly affected, at least to some extent, the amount of capital outflows, but it is not principally responsible. The AK Party government is holding an obscure “interest rate lobby” responsible for markets fluctuations and claims that it is out to hurt AK Party rule by damaging the image of the Turkish economy. Now, the AK Party government is continuing forward with this logic and has started a series of investigations. I do not think that these investigations will be able to uncover any manipulations of finance markets; it will simply find speculation. The difference between manipulation and speculation is obvious. Manipulation aims to affect prices, while speculation aims to react against expectations of radical price changes. I do not know any law prohibiting speculative actions in a market economy allowing free capital movement and the freedom of financial transactions. After the Fed's announcement, capital outflows occurred in many emerging markets, but I did not hear any blame being placed on plots organized by international lobbies in these markets. It is quite natural for investors to look after their profits. If the majority of them start expecting a rise in local interest rates due to a rise in US interest rates and an excess in demand of hard currencies enabling depreciation of the local currency, they start to sell their assets in the local currency and purchase euros or US dollars; it's as simple as that. Accusing those investors of being a part of an “interest rate lobby” plotting against the AK Party is nonsense. The climate of suspicion created by these accusations confirms my earlier worries. From June 10 to 24 I wrote three articles warning AK Party managers against leading the Turkish economy down a dangerous path. I said an open market economy's management cannot be based on fears of conspiracies but instead it must act according to policies that respect its market rules. Now, the AK Party's allegations have taken the central bank's monetary policy prisoner, and it cannot raise its interest rates without being accused of being a part of the “interest rate lobby.” What is happening now? The market interest rates of treasury bonds are actually over 9 percent, while the central bank is obliged to provide liquidities at 6.5 percent, in the best case. As long as investors think the central bank cannot move and that the Turkish lira will depreciate further, excess demand for hard currency will persist. So, the central bank will be continuing to desperately try to prevent this depreciation by selling dollars. Obviously, this is not a sustainable policy. Actually, the Fed is trying hard to convince investors that it has been misunderstood and that it will pursue its loose monetary policy for a while. This move may calm markets to some extent and for some time stop current capital outflows. But sooner or later, the Turkish economy will be facing capital outflows since its CAD is on the rise. There are only two options to tackle these outflows: Either the central bank raises its interest rates, or the government decides to establish controls on capital movement. The first option is off of the agenda under the current circumstances, which leaves the second option. Different kinds of capital controls aiming to mitigate the volatility of capital in and out flows exist in various emerging markets. Turkey may be part of them. Nevertheless, the AK Party does not forget that, quite logically, these controls are set not only for outflows but for inflows as well.

OECD forecasts low growth for Turkey

I hesitated between two subjects for today’s article. After a long period of deliberation, the draft of a new income tax law was finally submitted to Parliament on Wednesday.
On the same day, the Organization for Economic Cooperation and Development (OECD) published its new forecasts for the Turkish economy. I think it would be better to first talk about the OECD forecasts despite the importance of the tax reforms. This issue can wait until Tuesday, all the more so since we will be discussing it passionately in the coming weeks. Ali Babacan & Zafer Çağlayan: Prudence versus audacity According to the OECD’s “Turkey - Economic forecast summary (2013)”: “Following weak growth in 2012, as consumption and investment contracted and offset a surge in exports, the economy is now regaining momentum. Growth is projected to rise to above 3% in 2013 and, as the global recovery gathers strength, to pick up to 4½ per cent in 2014. Inflation and the current account deficit both remain above comfort levels, however.” I agree with the gist of this statement. But as usual, the devil is in details so, let’s look at them. The OECD’s growth forecast for Turkey this year is 3.1 percent. The first item to note is that the growth rate is well below the 4 percent targeted in the government’s Medium-term Economic Program (OVP). If growth remains at this level -- and I think that this is a rather realistic forecast -- the actual debate on monetary policy will become heated. The official growth target of 4 percent was already not well received by some ministers. The existence of contradictory approaches to monetary policy within the Justice and Development Party (AK Party) is not a state secret. Those partial to a push on the gas pedal continue to claim that interest rates are still high, despite the central bank’s recent reduction. It is worth reiterating that the expected real interest rates are currently in the negative zone, and this situation is currently considered by certain economists, including myself, as a potential risk for inflation and savings. I would like to note that there is dangerous confusion regarding the monetary policy. As is clearly expressed in the last Monetary Policy Committee (PPK) statement, lowering the interest rates is aimed at preventing further appreciation of the lira, which is already slightly overvalued, by discouraging excessive short-term capital inflows. At the same time, the central bank is trying to control credit expansion by squeezing the money supply in order to prevent an uncontrollable increase in domestic demand. This policy approach does not satisfy the proponents of acceleration. They demand an aggressive loosening of monetary policy. The low growth perspective is central to this opposition within the AK Party. If the debate has not yet turned into an open fight, this is because despite low growth, unemployment is not growing too fast. I have explained many times before in this column that this fortunate state of events is due to the high job creation capacity of growth prevalent in recent years. I do not think that this good fortune will continue in the near future. The OECD’s recent report forecasts an increase in the unemployment rate from 9 percent in 2012 to 9.4 percent in 2013. I believe that this forecast can be seen as a rather optimistic one. Another question mark regarding the OECD’s forecast is related to the current account deficit (CAD). The OECD thinks that exports of goods and services will increase by 4.9 percent and imports by 3.3 percent in 2013, causing a modest increase in the current account ratio to gross domestic product (GDP) that would reach 6.2 percent in 2013, up from 6 percent. I also consider this forecast rather optimistic. Yesterday, the Turkish Statistics Institute (TurkStat) published April’s foreign trade statistics. Seasonally adjusted exports had decreased by 1.6 percent compared to March, while imports had increased by 10.7 percent. Even if we exclude imports of gold, which showed a sudden jump in April, the growth rate of imports still remains high at 6.6 percent according to Bahçeşehir University’s Center for Economic and Social Research’s (BETAM) estimate. This is not a good sign for the CAD. As I already pointed out, the Turkish economy seems to be trapped in a low, unbalanced and poor quality growth regime. Even if GDP growth accelerates, as forecasted by the OECD, in 2014, this will be based mostly on domestic demand, further widening the current account deficit, as noted by the OECD. To sum up, it is quite probable that the GDP will remain below 4 percent in the future, causing a higher unemployment rate and CAD than expected. This state of affairs will be unacceptable for the AK Party government as the elections marathon will kick off soon.

Peace process going well but not the economy

The “peace process” aiming to put an end to the bloody and wearing “low intensity war” between the Turkish Armed Forces (TSK) and Kurdistan Workers' Party (PKK) militants is under way. The day before, the PKK officially announced the withdrawal of its armed teams from Turkey to northern Iraq. If this retrieval is hopefully terminated without any provocation, the first stage of the peace process will be completed and we will finally have a peaceful environment in eastern Turkey. Admittedly, this does not signify a definite solution of the “Kurdish problem.” Other steps, like a new constitution securing democracy and human rights for all citizens -- but particularly for Kurds, are a must. This is, for sure, not an easy task, but both sides estimate that the point of no return has already been passed.
Government postponed structural reforms The end of armed clashes along with the democratization of the Kurdish problem will certainly bring beneficial economic results, but the so-called “peace dividends” would not be, unfortunately, as high as expected. (See my March 18 column, “Peace dividends”) All of the energy and attention of the government -- particularly that of Prime Minister Recep Tayyip Erdoğan, whose energy and attention matter more than those of others -- are focused on the peace process. This is quite understandable, but this cannot be a pretext to neglect the economy, all the more since the economy is not doing well. Readers of this column are familiar with my worries, which are shared by most of the economists who are watching Turkey closely. A robust revival of domestic demand that would boost the sluggish growth is still not in sight. The leading indicators of the first two months were not very encouraging. The estimation of Bahçeşehir University's Center for Economic and Social Research (BETAM) for the yearly growth rate of the first quarter was 2.4 percent. (See my April 8 column, “A modest revival in sight”) Since then, the capacity use and real sector confidence index for March have been published. They are not encouraging, either. Another bit of bad news is in regards to the evolution of the real exchange rate. It had already entered the red zone, as defined by the Central Bank of Turkey, before the last interest rate loosening by the Monetary Policy Committee (PPK) a week ago. It had been expected that this strong loosening would prevent the Turkish lira from continuing to appreciate through a smooth nominal exchange rate adjustment. Nevertheless, the expected effect has not seemed to be produced, since the exchange rate of the currency basket, half of which is formed by the US dollar and the other half by the euro, continues to be under TL 2.10. International liquidity is still abundant, and the interest rates of Turkish Treasury Bonds, despite their historically low levels (around 5.5 percent), are still attractive for hot money. Yesterday, the most popular economic title in the press was: “5.6 billion USD capital inflows within a month.” Now, Turkish exporters desperately look after restoring competitiveness through a real exchange rate adjustment. Is further loosening of monetary policy needed? And if yes, is it possible? Let me first remark that the expected real interest rate is already in the negative zone, as inflation expectations are still well over 6 percent. I do not think that there remains too much room for the monetary policy cabale to contribute further to the domestic demand revival. More loosening could conflict with the fight against inflation. Under these circumstances, a balanced growth based on domestic and, at the same time, external demand seems pretty much impossible. There is still some hope to have a growth rate, say something between 3 and 4 percent, but it will be only an emanation of the domestic demand. So, we will be back again at the start -- an increasing current account deficit with, as a bonus, indomitable inflation. How to get out from these dilemmas? The only way, I believe, is a shock of reforms. All reform projects, such as severance pay reform, tax reform, etc., which are already finalized but postponed for political reasons, should be implemented as soon as possible. Other reforms aiming for things like more flexibility in the labor market and more fiscal autonomy for the universities must be designed and implemented. The only good news on the reforms' front is the recent admission by Parliament of a new electricity law which is able to make electricity production and distribution more competitive and more efficient. However, the Turkish economy, admittedly, needs more reforms as soon as possible.

Limits of monetary policy

The Monetary Policy Committee (PPK) of the Central Bank of Turkey decided to cut interest rates by more than expected during the monthly meeting held on Tuesday. The one-week repo rate (the policy rate) has been lowered from 5.5 percent to 5 percent, while the upper limit of the interest rate corridor (the lending rate) and its lower limit (the borrowing rate) have been cut, respectively, from 7.5 percent to 7 percent and from 4.5 percent to 4 percent. The size of the cuts surprised the business community as well as market players and provoked a hot debate among economists regarding the goals pursued by the central bank and its ability to reach these goals through these strong interest rate cuts.
Governor Erdem Başçı I think there is a large consensus regarding the main goal: The central bank wants to prevent further appreciation of the Turkish lira which has already crossed the red line set by itself. The central bank announced recently that the real exchange rate index would be entering the alarming zone over 120. The index is already there. Moreover, it will certainly be continuing to increase since the Turkish inflation rate is higher than its trading partners. The appreciation of the Turkish lira threatens the so-called “balanced growth” and the financial stability that is so intensely desired by the central bank through losses in the competitiveness of Turkish exports and excessive credit expansion. The following assertions from the MPC release should be underlined: “Recently, there is a reacceleration in capital inflows and credit growth hovers above the reference rate. The committee indicated that, in order to balance the risks on financial stability, the proper policy would be to keep interest rates low while increasing foreign currency reserves via macro prudential measures. Accordingly, it was deemed appropriate to further increase the reserve options coefficients, while delivering a cut in the short-term interest rates.” I fully agree with the central bank on the balanced growth goal. Economic growth exclusively based on domestic demand would unavoidably have an adverse effect on the current account deficit (CAD). The last figures show that the CAD-to-gross domestic product (GDP) ratio, which fell to 6 percent from 10 percent started widening slightly again. So, the desired revival in domestic demand must be kept under control while the supplementary growth must come from net exports. Doing so, exports have to rise more than imports. Now, it is not easy at all to achieve these double goals. Keeping domestic demand under control necessitates a rather tight monetary policy and the pursuit of fiscal discipline. The last cuts in the central bank's interest rates pushed the expected real interest rate in the negative zone; the indicative Treasury Bond rate went down to 5.5 percent while expected inflation remained over 6 percent. I do not think that there is further room for interest cuts. If this happens, credit expansion would be out of control, jeopardizing the credibility of the central bank in its fight against inflation. As for fiscal discipline, it is as solid as a rock according to the latest budget figures; the primary surplus is higher than that of last year in the first quarter. However, the actual macroeconomic framework does not seem to be able to produce growth close to 4 percent, which is targeted in the Medium-term Economic Program (OVP) and constitutes the minimal rate required to prevent unemployment to increase. Let me note that the unemployment rate, at 9.4 percent, is actually 0.4 percentage points over its level of last year. If the growth rate remains weak, admittedly the increase in unemployment will become more apparent and then more threatening for the government as electoral days are approaching. It would be worth noting at this point that the International Monetary Fund (IMF) forecasts only a 3.4 percent growth for the Turkish economy in its latest survey released this week. Balanced and at the same time sufficient economic growth seems quite elusive. The central bank would certainly prefer relatively low growth but sufficiently safe to secure economic and financial stability, while the government prefers robust growth enough to prevent an increase in unemployment. I do not think that the government cares about the source of the growth. This dilemma is capable of creating a serious rift between the central bank and some Justice and Development Party (AK Party) ministers in the coming months. By the way, the split is already quite visible. Mr. Zafer Çağlayan, minister of economy, reacted to the interest rate cuts by saying, “Good, but not enough.”

Are the brakes burning?

Zafer Çağlayan, Minister of Economy The expected reaction from the “growth lobby” to an increasing trend in unemployment was not delayed. Economy Minister Zafer Çağlayan, soon after the publication of December employment figures last Friday, reminded us how the rise in unemployment is unacceptable, for him and probably for the government as well. In his statement he once again used his favorite metaphor of burning brakes: “The brakes have begun to smell. Four or five months ago, I had warned to not push too much on the brakes. Unfortunately, the brakes have finally started to burn. But we have not been demoralized by this. I still hope to see better figures.”
Mr. Çağlayan then expressed his approach to economic policies: “From now on, we must step on the accelerator. … Each year we must grow by 6 percent. The way to reach this target is through expansion, not contraction. There is no need to be cautious on interest rates. They should be lowered.” In my column of Feb. 11 (“Worries on economic growth”), I wrote: “… I think the available information summarized above is enough to allow me to express some reflections on an important consequence of low growth. Further loosening monetary policy would risk jeopardizing the 5 percent inflation target. If the Central Bank maintains its actual stance, the already existing signals of an upturn in unemployment would become more perceptible. This will increase, for sure, the political pressures on the central bank's management.” I was not mistaken. Economic policies have arrived at a crossroad. The soft landing that was desired did not occur. The landing was rather hard, as the 2012 growth rate is expected to certainly fall below 3 percent. That said, Mr. Çağlayan is mistaken in believing that low growth is responsible for increasing unemployment. As I explained in my column on Saturday, despite the low growth rate, Turkish corporations and the state created lots of jobs last year, to the degree that the growth rate of employment exceeded that of gross domestic product (GDP). Unemployment is rising not because of insufficient employment but because of a strong growth of the labor force, particularly in the numbers of women. I believe these anomalies cannot maintain themselves, at least if economic theory and common sense prevail. I am afraid that Mr. Çağlayan, who hopes to see better figures in the coming months, risks being disappointed. If GDP growth maintains its pace at around 3 percent, rising employment will unavoidably decelerate. Even in the case of a deceleration in the growth of the labor force, I believe we should still expect rising unemployment. Unemployment is indeed the main threat to economic stability. I agree with Mr. Çağlayan that growth should be accelerated. The 6 percent target announced by the economy minister is out of range, but 4 percent is achievable. This could also be just enough to calm the worries regarding rising unemployment. But how? This is the critical question economists are asking themselves nowadays. The answers vary. The central bank and Treasury are confident that the 4 percent growth will come partly from external demand and partly from domestic demand. Let me remind you that last year domestic demand did not contribute at all to growth. However, the central bank and some economists do not think that radical changes in economic policies are needed. Some others, like Mr. Çağlayan, defend the argument that further loosening in monetary policy and the depreciation of the Turkish lira are necessary. At the moment, no one defends the loosening of fiscal discipline; Mehmet Şimşek, the minister of finance, announced last Friday that budget performance for the first two months is better than that of last year. This is good news. But if the state of the budget is revealed to be insufficient to revive domestic demand and/or exports fall further behind imports, what will happen to the moderately expansionist monetary policy and to the moderately tight fiscal policy? Personally, I think that there is no room for further lowering interest rates. The real interest rate has already come down to as low 1 percent, and the central bank is neither able nor willing to lower it. A limited depreciation of the Turkish lira will certainly aid growth, but the way to realize that process is not evident in the slightest. Thus it remains in the hands of fiscal policy. Let's hope that growth will resume in the coming months, just enough to stop the rise of unemployment and just enough to limit the unavoidable increase of the current account deficit.