SUMMARY OF THE MONETARY POLICY COMMITTEE DISCUSSIONS
Central bank: tcmb | Type: decision | Date: 2006-06-21

No: 2006-27
June 21, 2006
SUMMARY OF THE MONETARY POLICY COMMITTEE DISCUSSIONS
Meeting Date: 7 June 2006
Inflation Developments
1. Inflation pursued its upward trend in May and reach ed 9.86 percent. The
exchange rate movements arising from recent fluctua tions in financial markets have
started to affect prices through the cost channel. It is estimated that the pass-through
effect of exchange rates on May inflation, especial ly through increments in prices of
items like petroleum products, electrical appliance s, package tours abroad and gold,
was approximately 0.65 percentage point .
2. Unprocessed food prices continued to increase and a ffected inflation adversely
in May, with a rise of 1.33 percent. Especially the rate of increase recorded in fruits
(30.97 percent) was considerably above the past sea sonal patterns. Annual price
increases in processed foods are rather lower and m ore stable compared to those of
unprocessed foods, which might indicate that the pr ice increases in food prices are
supply-driven. Prices of unprocessed foods, which u sually decrease in summer, have
the potential to positively affect inflation in Jun e and July. Nevertheless, it is
anticipated that the annual rise in prices of unpro cessed foods is likely to continue
above the general inflation trend for a while. Mean while, the monthly increase of
10.88 percent in clothing and footwear, which was m ostly attributed to seasonal
factors, was another determinant of May inflation.
3. The effects of exchange rate developments are both faster and higher on
producer prices than they are on consumer prices. A ctually, producer prices responded
very quickly to these developments in May where the annual inflation increased
rapidly. It is projected that the upward trend will continue in June, as well. It should be
reiterated that there is no policy target designated for producer prices.
Factors Affecting Inflation
4. Recently published data show that supply and deman d developments are
consistent with the projections presented in the In flation Report of April. The
investment tendency has remained strong; the revival in demand has continued without
acceleration; and output performance has been robust.
5. However, the outlook needs to be revised in light of the latest developments.
Due to recent changes in international liquidity co nditions, emerging markets,
including Turkey have been adversely affected and f luctuations have been experienced
in financial markets. Such a development can be att ributed to expectations that
developed countries would continue to tighten their monetary policies in response to
inflationary pressures arising from rapid expansion of global output. As this
development occurred at a time when the current acc ount deficit widened and
coincided with other perceptions of domestic uncert ainty, the Turkish economy was
affected more seriously than other developing countries. For a better comprehension of
monetary policy decisions, the potential impacts of these factors on the inflation
outlook should be evaluated.
6. Domestic demand, which has been high for quite a w hile, is expected to slow
down in the months ahead. Price increases in import ed goods, rise in interest rates, and
increased volatility in financial markets would dec elerate both consumption and
investment demand in the short run. With these deve lopments, imports of consumption
and investment goods would decrease. However, it is projected that the slow-down in
imports of intermediary goods would be limited due to the high level of crude oil
prices and the related structural factors.
7. Even if the volatility in exchange rates curbs dom estic demand in the short-run,
exchange rates would not have an adverse impact on growth in the medium-term due
to the rise in net foreign demand. However, the rec ent developments are not confined
to fluctuations in exchange rates. It is expected t hat the slowdown in domestic
demand, arising from the rise in loan rates, shorte ned maturities, decreased consumer
confidence and increased foreign financing costs, w ould be more pronounced than the
increase in foreign demand. In other words, the pro bability of demand-pulled inflation
has decreased for the upcoming period.
8. The slowdown tendency in the rise of commodity pri ces can be seen as a
favorable development for future inflation. The upw ard pressure on commodity prices
has become more limited as global risk appetite dec reases. Moreover, the increasingly
intensifying international competition is expected to restrict the prices of most
imported inputs in the upcoming period.
9. It is anticipated that unit labor costs, which bea r significance as to inflation, will
remain at low levels in the medium term. The rapid increases in investments during the
last three years will continue to induce further pr oductivity. Furthermore, the ongoing
upward trend of the labor force participation, whic h is caused by structural factors,
continues to be a factor that restrains labor costs . In conclusion, it is expected that unit
labor costs, which are crucial for price dynamics, will support the decline in inflation
in the medium term.
Outlook and Monetary Policy
January-April 2006
10. First of all, it is necessary to remember the peri od prior to May 2006. The
Central Bank had previously forecasted that the inc rease in annual inflation in the first
four months of 2006 would not disrupt the medium-te rm inflation dynamics. Even the
high inflation figures in April did not change this view. In April, the number of
products whose prices increased in the CPI basket w as lower compared to the same
period of the previous year. This was indicating th at the increase in inflation mainly
stemmed from the temporary price increases in some sub-items rather than the
deterioration of general pricing behavior. Indeed, when the sub-items are analyzed, it
is seen that the factors that affected inflation in the first four months of the year were
generally beyond the control of monetary policy. C onsequently, monetary policy was
not tightened against the shocks related to tax adj ustments, oil prices, gold prices and
prices of unprocessed food, which generally origina te from supply conditions and are
of a temporary nature. Although annual inflation in creased in this period, medium-
term expectations did not deteriorate, in a manner confirming the consistency of the
maintained policy path.
May 2006 and Onwards
11. However, international liquidity conditions began changing from May onwards,
due to the flow of funds from developing countries to developed markets that are
perceived to be safer. In this way, one of the sign ificant risks mentioned in the
Inflation Report has materialized and there appeare d the need to re-assess inflation
outlook and monetary policy stance.
Given the recent financial market fluctuations, the annual inflation figures to be
recorded in the next months might further go up tem porarily, with the pass-through
effect of the exchange rate movements. The Monetary Policy Committee has deemed
it necessary, on 7 June 2006, to revise the policy rates in order not to let such
temporary developments cause permanent effects on t he medium-term expectations
and pricing behaviors, and also to make sure that t he medium-term inflation trend is
kept in line with the targets.
13. It is expected that the rise in annual inflation w ill continue in June and July and
inflation will remain above the 2006 year-end targe t. The direct effect of exchange
rates on inflation will mainly be observed in June. Although the downward trend of
crude oil and gold prices will partially limit the effect of exchange rates on petroleum
and gold prices, annual inflation will rise in June , as well. In July, the direct effects of
exchange rates on inflation will continue with a gr adual decline. The rise in annual
inflation might also continue. The direct effects a re expected to decrease remarkably
from August onwards. Given the currently available information and considering that
the base effect caused by the tax levied on tobacco products in 2005 will reduce annual
inflation by one percentage point, it is estimated that the annual inflation figures of
August will be lower than those of July.
14. In fall 2006, demand conditions are expected to be the main determinant of
price dynamics. In light of available data, the ana lysis made in the previous part does
not foresee an inflationary pressure originating fr om domestic demand in the
upcoming period. In this respect, it is considered that the indirect effects of the
volatility in exchange rates on inflation will rema in modest along with the slow-down
in domestic demand, and will not reflect upon 2007. Under the main scenario where
monetary policy adopts a cautious stance, expectati ons are well-managed and fiscal
policy is conducted consistently with the inflation target, it is foreseen that inflation
will display again a downward trend in the medium t erm and converge to the point-
target set for end-year 2007.
15. In consideration of these evaluations, the Monetary Policy Committee has
decided to increase the policy rates by 1.75 points . In light of currently available
information, the policy rates are less likely to ri se in the short-term, compared to the
previous period. However, it should be reminded tha t the direction of monetary policy
decisions might change conditional on developments pertaining to inflation outlook.
Policy decisions will be based on a perspective in which inflation would converge to
the target towards the end of 2007. Therefore, acco mpanied by the envisioned decline
in inflation, the direction of policy rates would b e downward as well in the medium-
16. In the coming period, the Central Bank will contin ue to closely monitor the
factors affecting the inflation outlook as well as the developments in international
liquidity conditions. In this context, policy instr uments will be used effectively to
achieve the medium-term inflation targets.
Risks and Policy Alternatives
17. Decisive steps have been taken towards macroeconom ic stability in the last few
years. Significant achievements were made in areas of fiscal discipline and financial
deepening, which are the prerequisites for the impl ementation of a sound monetary
policy. This enables the Central Bank to utilize sh ort-term interest rates, the main
policy instrument in the inflation-targeting regime , efficiently. There is no doubt that
there exist some uncertainties regarding the rate a nd magnitude of the channels
through which monetary policy affects inflation. Ho wever, such uncertainties are not
peculiar to Turkey; the central banks in developed countries also face the same
uncertainties. Nevertheless, with regard to the imp act of monetary policy on inflation,
it can be stated that pursuing tight monetary polic y in an economy where there is no
fiscal dominance decreases the demand and cost-push ed inflationary pressures in the
medium-term. The recent decision of the Monetary Po licy Committee should only be
evaluated within this framework.
18. Despite the determined stance of monetary policy, t here are some risks
regarding the inflation outlook in the medium-term. The tightening process of the
monetary policies of The Federal Reserve, European Central Bank and the Bank of
Japan still continues. In consideration of the avai lable information, it is not possible to
say that the uncertainties related to the global li quidity conditions have been entirely
disappeared. In case the global risk appetite decli nes further and the outflow of funds
in emerging markets accelerates in the upcoming per iod, the Central Bank will not
hesitate to give the necessary policy response in o rder to control the medium-term
inflation expectations.
19. Pricing behaviors have been changing in recent yea rs, thanks to the reduced
inflation rate, the floating exchange rate regime, increased competition and economic
policies focused on stability. In the last four yea rs, thanks to the increased confidence
in economic policies, inflation targets have become a variable that is increasingly
referred to in pricing decisions. The reversal of t his tendency stands as one of the
significant risks for the upcoming period. It is ob served that the medium-term
perspective has not yet become prevalent in the eco nomy, due to habits inherited from
the past periods of high inflation, and thus, the s hort-term developments still have the
potential to cause permanent impacts on inflation e xpectations. In this context, the
issue of expectations management is still of great importance. Currently, inflation
expectations for next year and the following year a re 6.66 percent and 5.37 percent,
respectively. In other words, economic agents antic ipate that the downward trend in
inflation will continue in the medium-term but they also expect inflation to be above
the path consistent with the targets. In the upcomi ng period, the impact of the rising
tendency of the expectations on pricing behaviors will be cautiously monitored.
20. It should be kept in mind that price stability is a sine qua non for sustainable
growth. Therefore, the Central Bank will maintain i ts cautious stance until the price
stability perception is firmly established within t he economy. Much has been achieved
on the way to macroeconomic stability in recent yea rs. The implementation of prudent
macroeconomic policies played a significant role in these achievements. The
environment of stability should continue in order t o avoid a reversal in gains achieved
and to keep worries about risk perception limited. In a period where the global risk
perception tends to rise, avoiding any implementati on that would deteriorate the
expectations is of critical importance. In this fra mework, the continuation 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 the deter mined steps taken in recent years
towards the above-mentioned reforms in the upcoming period will help us to overcome
the changes in international conjuncture with minimum fluctuation.