Expected rates float above the targets. So do realizations. This is a critical mistake

Number four on the policy mistakes lists is the policy to curb lira depreciation. In football, the goal keeper is caught on the wrong foot when he or she cannot prevent an attack as he or she cannot reverse the move already started to one end of the goal while the attack comes to the other. Similarly, given the extraordinary conditions across financial markets, that is, the risk that the volume of capital flows to Turkey changes sharply and suddenly, it was highly probable that the lira depreciation policy catches Turkey on the wrong foot.

And so it did: the Central Bank (CB) was wrong-footed several times in the last couple of years. Some attempts to curb depreciation by cutting interest rates were soon followed by a necessity to raise the rates due to the exchange rate hikes caused by drops in risk appetite. The policy to keep exchange rate above inflation led to increases in inflation. Therefore, Turkey’s inflation stood above those of rival exporter countries. In other words, the competitive advantage enabled by the CB’s exchange rate policy has proved short-lived whereas it brought a rising inflation as a side effect.

Number five on the list is the CB declaring new objectives even though it lacks the instruments needed to achieve them. Chief among these was the CB’s attempts to limit credit growth. It is the Banking Regulation and Supervision Agency (BRSA) which has the instruments to limit credit growth; but the CB tried to influence credit growth with required reserve ratio. It might be that the CB had no other option for the BRSA did not step up for this task, as I mentioned before. Or the CB might have another reason for choosing the reserve requirement tool over interest rate. Whatever that reason is, the attempt has evidently proven futile.

The number three mistake is linked to the first two. At the outset of the “implicit” inflation targeting regime declared in 2002, people were convinced that the CB will fight with inflation with each and every instrument at its disposal. Inflation rates declined constantly until 2006 and were realized below the targeted levels in each year. Therefore expectations were always below the targets, which is the reference point for my claim that the public was convinced. After decades of high inflation, the monetary policy in play in the 2002-2005 period was a substantial success.

Later it all started to get out of hand. Currently, due to the multi-objective monetary policy practice, there is no public perception on the presence of an anti-inflationary agenda. Expected rates float above the targets. So do realizations. This is a critical mistake; because if the CB ever decides to genuinely fight with inflation with actually tool other than empty talk, it has to start “from scratch.” It is not easy to convince people once again. And while the disadvantage is huge, the multi-objective policy did not enable much gain: has the current account deficit declined permanently? Was credit growth limited to desired levels? No, not at all.

This commentary was published in Radikal daily on 11.02.2014