SUMMARY OF MONETARY POLICY COMMITTEE DISCUSSIONS
Central bank: tcmb | Type: decision | Date: 2006-06-28

No: 2006-36
June 28, 2006
SUMMARY OF MONETARY POLICY COMMITTEE DISCUSSIONS
Meeting Dates: 20 June and 25 June 2006
Inflation Developments and Short-Term Forecasts
1. The rise in inflation in the first five months of the year mainly stemmed from
supply-oriented factors. Cumulative increase in the prices of unprocess ed food
group, which remained almost the same in the first five months of 2005,
increased by 11.4 percent in the same period of 2006. Besides, the pass-
through effect of exchange rate movements on May inflation was
approximately 0.65 percentage points. Excluding the said effects, it i s
observed that the rate of inflation in the first five months of the y ear is close to
that of the same period in 2005. This observation shows that there were no
significant changes in the main trend of inflation in the first five months.
2. Prices of unprocessed food will very likely make a positive contributi on to
inflation in June and July. Nevertheless, it is anticipated that the direct effects
of recent volatilities in the exchange rates on consumer prices w ill persist in
June and July and annual inflation will increase during the said period.
Meanwhile, annual inflation is expected to decline in August due to the
removal of the effect resulting from the high-rated increase in prices of the
tobacco and alcoholic beverages group in the same month of 2005.
3. With respect to the assessment of price dynamics in the following months, it
would be helpful to evaluate supply, demand and cost developments from
forward-looking perspective.
Factors Affecting Inflation
4. In recent months, the revival in production and demand continued without
further acceleration, and investment expenditures maintained their st rong
course. However, the macroeconomic outlook needs to be reviewed in the
light of recent fluctuations in the financial markets that started in May.
5. Fluctuations in the financial markets, before all else, affected costs of
imported inputs. Even if the ongoing increases in partial labor productivit y in
the manufacturing industry in the first quarter of 2006 ensured the continuance
of the downward trend in unit labor costs, the said trend will not be adequa te
to compensate the high-rated increase in costs of imported inputs. As a matter
of fact, the upcoming three-month tendency of the average unit cost indic ator
of the Business Tendency Survey (BTS) displayed a rapid increase in May.
6. Fluctuations in the financial markets also change demand conditions. The
realizations in consumption and investment expenditures point to a strong
course in domestic demand in the second quarter of the year. However, ri sing
interest rates, the perception of uncertainty resulting from ongoing fluctuations
and the relative price increase in imported goods will unfavorably af fect
domestic demand in the following period. With rising interest rates and
shortening maturities, the rate of increase in credits has alre ady declined.
Expectations in the Consumption Tendency Survey indicate a slowdown in
demand. Actually, the upcoming three-month tendency of the BTS domestic
market orders and sales indicators showed sharp declines in May.
7. These developments are expected to lead to contractionary impacts on the
foreign trade balance and thus, on the current account deficit during the rest of
the year. It is anticipated that export performance, especially in labor-intensive
sectors, will be positively affected due to the decline in foreign currency-
denominated unit wages arising from the depreciation of the New Turki sh lira.
Meanwhile, it is expected that imports, which has recorded high incre ases
recently, will slow down starting from July. Even though no decreases are
expected in imports of intermediary goods due to high levels of energy prices,
imports of capital and consumption goods, which have recorded high growth
since the second half of 2005, are expected to decrease substantially on an
annual basis in the second half of 2006.
8. It is projected that despite of the increase in net foreign demand, the slowdown
in domestic demand will be dominant in the short run and the net effect of
recent fluctuations on the total demand will be of a contractionary na ture. In
this framework, the downward pressure on inflation exerted by demand
conditions is expected to increase in the second half of the year.
9. Although the investment tendency is estimated to lose pace in the se cond half
of the year, the strong investment realizations of the last three years is
predicted to continue to support productivity increases in the medium-term .
Moreover, the expanding tendency in labor supply in urban areas stemming
from the structural transformation in demographic factors and the ag ricultural
sector will continue to suppress labor costs. In conclusion, it is antic ipated that
unit labor costs will continue to contribute to the disinflation process in the
coming period as in recent years.
10. Despite the fact that international commodity prices entered a dow nward
trend after the high-rated increase in May, they still remain at relatively high
levels. Accompanied by the movements in exchange rates, these developments
led to an increase in TL-denominated costs of commodities and other imported
intermediary goods. The extent and duration of the indirect effects of
unfavorable developments in imported input costs on consumer prices will
chiefly depend on the course of demand conditions and expectations.
11. The second Expectations Survey data for June reveal that the ongoing
fluctuations in financial markets have a negative impact on inflati on
expectations. Both the annual inflation expectations for the 12-month period
and for the end of the 24-month period are above medium-term targets. The
Monetary Policy Committee considered the deterioration of the expec tations
for the end of the 24-month period as a significant development.
The Monetary Policy Decisions of 20-25 June 2006
12. In the ordinary meeting of the Monetary Policy Committee dated 20 J une
2006, the Committee evaluated the data announced after the unscheduled
meeting of 7 June 2006 and other developments and then, stated that there was
no significant development that would affect the decision-making process
between 7-20 June 2006. Parallel to this evaluation, the Committee maintained
the policy position of the previous meeting. In the brief announcement made
after the said meeting, it was clearly stated that monetary policy would be
conducted effectively in the event of an unfavorable development that might
affect the medium-term inflation outlook. In this context, the Committ ee
especially drew attention to medium-term expectations, internationa l liquidity
conditions and pricing behaviors, and announced that it will closely monitor
developments in these factors.
13. There were striking developments in international liquidity conditions a nd
expectations in the days following the meeting of 20 June 2006. The increa se
in the movements in international financial markets continued to exert
pressure on both exchange rates and medium and long-term interest rat es in
developing countries beyond the extent implied by economic fundamentals.
Meanwhile, Turkey has been significantly influenced by these development s
because of the structure of the portfolio held by non-residents. Furthermor e,
the Expectations Survey of 22 June 2006 reveals that medium-term
expectations are continuing to increase.
14. Following these developments, the Monetary Policy Committee gathere d on
25 June 2006 to assess the developments and to discuss the measures to be
taken. Members of the Committee have reached a consensus that recent
volatility has the potential to affect the expectations and the ri sk perceptions,
and thus disinflation process in the medium term. And the Central Bank w ill
not allow this to happen. In this context, it is announced that the Central Bank
will start deposit purchase auctions in order to reduce the excess New Turkish
Lira liquidity in overnight money market via open market transactions, with
the aim of increasing the effectiveness of the monetary policy de cisions.
Hence, the need for unscheduled Monetary Policy Committee meetings ha s
been reduced. Governor Yılmaz has submitted the regulation, which has been
drawn up for this purpose, to the Committee. Moreover, liquidity conditions in
the foreign exchange markets have been thoroughly assessed and shrinkage of
foreign exchange liquidity was identified. Due to the fact that an effectively
operating foreign exchange market is a prerequisite for price st ability, the
Committee has expressed its full support for the effective inter vention of the
Central Bank Head-Office in order to provide foreign exchange liquidit y via
its instruments and mechanisms. At its meeting of dated 25 July 2006, t he
Committee has reviewed policy rates and has decided to further str engthen
monetary tightening in order to improve medium-term inflationary
expectations. Hence, the Committee has showed its determination to f ight
against inflation and stated explicitly that it is ready to do w hatever necessary
to achieve medium-term targets.
15. In the light of these decisions and under the assumption that the cautious
attitude of monetary policy continues, the assessments made by the Committee
on the medium-term outlook can be summarized as:
16. The Committee foresees that domestic demand and growth will slow down in
the second half of 2006. Though this downward trend is not expected to reach
stagnation level, it is predicted that growth rates will decline drastically
compared to the first half of the year. Despite of the fact that economic
activity is expected to recover gradually in the medium term, it will not be a
surprise to witness low growth rates in the first half of 2007.
17. The forecasted contraction in demand will also contribute to the ease of the
secondary effects of cost-oriented pressures on inflation. In this cont ext, the
impact of the latest movements in exchange rates on prices is e xpected to
diminish from August onwards. Even if annual inflation is predicted to decline
in August, inflation may display fluctuations in the fall due to intens ive
seasonal price adjustments. However, it is estimated that inflat ion will regain
stability and that the main tendency will display a significant decline as of the
second quarter of 2007 onwards.
18. The latest decisions of the Central Bank have increased the prospect s for 2006
year-end inflation staying at a single digit-rate. More importa ntly, the effects
of the latest exchange rate fluctuations on inflation are less l ikely to reflect in
2007. In this context, the Committee believes that the medium-term ta rgets are
achievable. Undoubtedly, these assessments rest upon the assumptions that
fiscal discipline will continue, the consistency of incomes policy w ith the
inflation targets will be maintained and expectations will be managed wisely.
Risks and Policy Response
19. The effects of the rises in energy and commodity prices and the r apid
expansion of global output on inflation expectations in developed countries
remained limited until recently. However, the upward tendency in infla tion in
these countries is considered an important risk factor. The monetary
authorities of developed countries are growing more and more cautious about
inflation and monetary policy. The Monetary Policy Committee deems the
possibility of sustained global inflation concerns and continued monetary
tightening process in developed countries as one of the most important ri sk
20. In the event of the occurrence of risk that may lead to further decl ine in the
global risk appetite and new fluctuations in Turkish financial markets , the
Central Bank will not respond to the direct effects stemming from relative
price changes, but will not allow any deterioration in expectations a nd general
pricing behavior. Accordingly, the Central Bank will continue to employ a ll
policy instruments effectively in the upcoming period, as before.
21. According to Committee members, another significant risk relating to the
upcoming period is the possibility of deterioration in pricing behaviors. T he
studies that have been carried out at the Central Bank show that infl ation
targets have become a variable that is more frequently referre d to in pricing
decisions. Even though the upward tendency recently observed in inflation is
temporary, the memories of high inflation are still very fresh. T herefore, a rise
in the backward-looking indexation method or indexation to a variable other
than the target in pricing behavior is a risk factor that should be a voided. The
Central Bank’s response to this risk has been to introduce a fast and harsh
monetary tightening package. Even if some short-lived deviations from t he
inflation target have become likely to occur in case of unpredictable shocks,
the CBRT has given the policy response necessary for achieving the medium-
term targets and will continue to do so in the future. If economic unit s made
their medium-term plans according to the target inflation, the magnitude of the
response would be smaller and it would take less time to get back on the main
track. The primary objective of the Central Bank is to make the me dium-term
inflation expectations consistent with the targets, because only the n would the
inflation-targeting regime have been successful.
22. The Committee has concluded that monthly price data are sometimes
misinterpreted by economic units and that these misinterpretations c an lead to
irrational deteriorations in expectations. Especially in the rece nt period, it is
observed that economic units increasingly tend to infer strong judgments on
medium-term inflation without analyzing the price data in details. Therefore,
in order to contribute to the accurate comprehension of monthly inflation da ta,
a technical note on inflation developments will be published within two day s
following the announcement of price indices. The Inflation Report, assess ing
the reflections of recent economic developments on the medium-term inf lation
outlook and involving quantitative forecasts, will be published on 28 July
23. Thanks to sustained public fiscal discipline and structural reforms, f iscal
dominance is no longer a factor of concern with respect to monetary pol icy
and they also help the Central Bank to use policy instruments more
effectively. It should be borne in mind that price stability is a pr erequisite not
for only financial stability, but also for sustainable growth. The ea se of
uncertainties about inflation will enable the decline of long-term i nterest rates
and this will have a favorable impact on both the financial sector and the real
sector. In this framework, the Central Bank’s focus on price stabili ty
contributes to social prosperity in the medium and long run.
24. Much has been achieved on the way to macroeconomic stability in recent
years. The implementation of prudent macroeconomic policies has played a
significant role in these achievements. The environment of stability should
continue in order to avoid a reversal in the gains achieved and to keep
concerns about risk perception limited. In a period where the global ris k
perception tends to rise, avoiding any implementation that would deteriora te
the expectations is of critical importance. In this framework, the continuance
of the adaptation and convergence process to the European Union and the
uninterrupted implementation of the structural reforms related to our economic
reform program, as planned, are crucial. The continuation of determined s teps
taken in recent years towards the above-mentioned reforms in the upcomi ng
period will help us to overcome the changes in international conjuncture w ith
minimum fluctuation.