Clearly, should the relatively positive climate that emerged along with the beginning of 2012 continues, Turkey’s inflation will be affected positively.

Annual inflation in 2011 stood at 10.4 percent. After January 2012, the rate increased to 10.6 percent. H and l indicators also increased slightly in January: annual inflation increased by 0.2 points to 8.8 percent under the H index and by 0.3 to 8.4 percent under the l index. The Central Bank of Turkey, CBT, expects a remarkable drop in annual inflation particularly during the last quarter of 2012. The mid-point of year-end inflation forecasts is 6.5 percent, above the 5 percent target. Can this forecast be realized? 

It is possible that this forecast will be realized. First, though higher than others, the official growth estimate at 4 percent implies that the pressure of domestic demand on inflation will be lower compared to 2011. It is evident that at lower growth rates, this pressure will be even lower. If no surprise tax and price hikes are introduced, inflationary dynamics will be determined by the changes in exchange rate and import prices in foreign exchange (FX) terms. The climate since the beginning of 2012 signals that exchange rate will have a positive impact on inflation:

First, the European Central Bank (ECB) introduced a quantitative easing after European leaders “saved the appearances” with measures to ensure and sustain fiscal discipline. The ECB injected €489 billion to the market via low-interest three-year loans to banks. Another lending facility will be introduced on February 29. In addition, reserve requirements were halved and collateral quality requirement was lowered to facilitate lending to banks.

Before the mentioned decisions, European banks were faced with three main challenges: first, since May 2011, they had been facing difficulty in issuing bonds to finance the repayment of earlier bonds. Second, bonds of troubled European states losing value had been affecting banks that held these bonds. Third, the European Banking Authority had identified that European banks had a capital deficit of €120 billion and asked banks to close the deficit before June 2012, so that the capital adequacy requirements would be met. The Authority allowed banks to cut the size of balance in order to meet the adequacy ratio, which raised the expectations that troubled banks will lower the credit supply substantially. The recent decisions of the ECB relieved banks to a certain extent compared to the last four months of 2011. 

Risk appetite grew
Then came the remarks by the Federal Reserve, FED. With the aim to make policy decisions more understandable and reduce uncertainties about the future value of the policy rate, the FED announced that it will not hike the policy rate until 2014. In addition, the possibility of a new quantitative easing by FED was started to be discussed. A hike in the policy rate or the reversal of the earlier monetary easing was already off the table for 2012. After these remarks, financial markets were relieved for 2013, as well.

It is evident that the above developments have increased risk appetite, which fell sharply during the last four months of 2011. One of the chief indicators is the drop in market interest rate on sovereign bonds of France and Italy. Another one is the appreciation of the currencies of emerging market economies. The Lira exchange value of euro-dollar basket, which once had reached 2.20, has now decreased to 2.03.

Clearly, should the relatively positive climate that emerged along with the beginning of 2012 continues, Turkey’s inflation and growth will be affected positively. Will this climate continue? Evidently, it all depends on Europe. At this point it is difficult, in fact impossible, to come to a conclusion.

This commentary was published in Radikal daily on 04.02.2012