The direction to which the headline inflation will heads relates basically to that exchange rate will head.

Inflation statistics for October were no surprise: consumer price inflation (CPI) as well as the headline inflation that excludes the price changes for certain goods and services (the l indicator) decreased, with annual CPI at 7.8 percent and headline inflation at 6.1 percent currently. The downturn in headline inflation is particularly remarkable: it decreased by 2.1 percentage points since April.

The first question figures raise is: should we expect a harmonious downturn in CPI? I would like to revisit the recent past for this. Actually, this is an issue I used to address quite often: except a couple of months, CPI has been floating above the headline inflation and the gap has been significant: since the beginning of 2006, average annual CPI was 8.5 percent compared to average headline inflation at 6 percent. Over a shorter period of analysis, the result is similar with average CPI at 7.6 percent and average headline inflation at 5.3 percent. The gap is still large and the latest figures above validated that the difference prevails.

In short, evidence suggests that even if headline inflation decreases to 5 percent level, let’s say, the CPI will be higher. In other words, in order to meet the CPI target of 5 percent as stated in the Medium Term Plan, headline inflation should be much lower. But is it possible?

Below is a figure that shows the changes in the annual headline inflation (the l indicator) since 2009. The vertical line at October 2010 represents the start of the Central Bank’s new monetary policy. Headline inflation then was 2.5 percent. Until January 2012, inflation rate increased continuously and peaked at 8.4 percent. Hence, headline inflation increased by 6 percentage points in 15 months.

Concerning headline inflation, the key feature of this 15-month period is as follows: in the late 2010, the Central Bank introduced a policy that among others aimed to lower the lira’s value. The Bank’s reports involve assessments on this policy objective and results. For some, you can check the first pages of the recent inflation reports. The Bank sustained this policy roughly until August 2011.

As the mentioned reports also emphasize, the value of emerging market currencies increased against dollar and euro while that of lira decreased. Then Europe got into trouble and the Central Bank ended the policy. With the weakening of international risk appetite, FX inflows slowed down and the depreciation of the lira intensified. In a nutshell, the core reason for the upwards trend in headline inflation until January 2012 was the extensive depreciation of the lira.

Under these circumstances, the direction to which the headline inflation will heads relates basically to that exchange rate will head. And the answer is not simple: first, it depends on the particular steps the Central Bank will take. Second, it depends on how the risks concerning Europe and the US will be shaped. I have no intention of leaving this equation unsolved. I will continue with this subject.

This commentary was published in Radikal daily on 06.11.2012