Durmuş Yilmaz: Turkey's monetary and exchange rate policy for 2007
Speech by Mr Durmuş Yilmaz, Governor of the Central Bank of the Republic of Turkey, at the Central
Bank of the Republic of Turkey, Istanbul, 13 December 2006.
* * *
General framework of the monetary policy
A brief evaluation of the first year of the inflation targeting regime
The Central Bank of the Republic of Turkey (Central Bank) adopted the formal inflation-targeting
regime at the turn of 2006, and since that time has implemented a policy consistent with the principles
laid out in the policy statement entitled "General Framework of Inflation Targeting Regime And
Monetary And Exchange Rate Policy for 2006" and released on 5th of December, 2006.
Four Inflation Reports have been published in 2006, in January, April, July and October. These reports
have explicated the Central Bank's inflation forecasts and policy perspectives. The main messages of
the reports have been shared with the public each time in by means of press conferences.
The Monetary Policy Committee (Committee) held regular meetings throughout 2006, in addition to the
interim meetings held in June, in line with the pre-announced annual timetable to determine policy
rates. Press releases explaining the rationale of decisions and the Committee's policy stance have
been published along with interest rate decisions. Moreover, the summary reports of the Committee's
discussions have been released within five working days following the meetings.
In the first year of the inflation-targeting regime, some supply-side shocks were experienced, which
caused inflation to materialize above the path consistent with the target. The Central Bank explained
the reasons of this deviation through open letters written to the Government, took the necessary
measures to put inflation back on track consistent with the target and shared its evaluations pertaining
to the timing of convergence to the target with the public in a transparent manner.
These implementations not only strengthened the communication framework of monetary policy, but
also played an important role in shaping the expectations. Although the inflation rate has stabilized at
around 10 percent-level for a long time due to the supply-side shocks experienced in 2006, the fact
that the inflation expectations for the next 24 months is around 5.5 percent as of today is a clear
evidence of the success achieved in the inflation-targeting. However, being ultimately focused on price
stability, the Central Bank cannot be content with what has been achieved until medium-term
expectations are consistent with the target.
As a result, important steps were taken in 2006 on the way to transparency, accountability and
predictability, which are the main principles of the inflation-targeting regime. This press release aims to
review the strategic as well as the operational framework of monetary policy in light of the first year's
experience and to lay down the principles for 2007. In the first part of the text, the general framework
of monetary policy will be presented, and in the second part exchange rate policy and liquidity
management issues will be considered.
Inflation targets
Inflation targets will continue to be defined as the end-year rate of inflation calculated by the annual
percentage change of the Consumer Price Index (CPI) in the upcoming period. In the press release
regarding the monetary and exchange rate policy for 2006, the target horizon was set as three years
and this time frame will be preserved for 2007. Taking into account the structural transformation of the
economy, the transition from chronic high inflation to low inflation, and the process of convergence to
the developed countries, a target of around 4 percent is considered appropriate for the medium-term.
Therefore, inflation targets for 2007 and 2008, which were previously announced as 4 percent, are
maintained and the inflation target for 2009, which was scheduled to be announced at the end of this
year, has also been determined as 4 percent. As the structural transformation and convergence
process is completed in time, it will be possible to target lower inflation rates.
Uncertainty band
In Article 42 of the CBRT Law it is stipulated that "The Bank shall submit information to the
Government in writing and inform the public disclosing the reasons for the incapability to achieve the
determined targets in due time published or the occurrence of the possibility of not achieving and the
measures to be taken thereof". However, it does not specify the size of the deviation from the target
that will require such an explanation. Therefore, in order to clarify this mechanism and facilitate its
operation, the Central Bank has set a symmetrical uncertainty band of 2 percentage points in both
directions around the point target.
It has been decided to keep the uncertainty band around the target at 2 percent for 2007 as well. The
path consistent with the end-year target and the uncertainty bands defined for the end of each quarter
of 2007 are shown in Table 1. In case the figures go outside the band, the Central Bank shall submit a
separate report to the Government disclosing the reasons for the deviation and the measures to be
taken for convergence to the target and share this report with the public. The path shown in Table 1
will also be used as performance criterion for the IMF reviews within the framework of the Stand-by
program.
Table 1: Inflation path consistent with the end-year target and the uncertainty band
March June SeptemberDecember
Uncertainty Band (upper
11,2 8,7 7,3 6,0
limit)
Path Consistent with
9,2 6,7 5,3 4,0
the Target
Uncertainty Band
7,2 4,7 3,3 2,0
(Lower Limit)
The difference between the targets and forecasts
In last year's policy statement regarding the general framework of the inflation-targeting regime, it was
stated that the inflation target would only be changed in the event that sharp and long-term deviations
from the target are expected or the medium-term targets no longer make sense due to factors beyond
the control of monetary policy. It was also stated that temporary shocks would only change inflation
forecasts rather than inflation targets and the points of reference to be used by economic agents
would be inflation forecasts for the short-term and the inflation target for the medium-term. This policy
approach was put into practice after the supply-side shocks of 2006. The inflation forecasts were
updated in July and it was announced that inflation would stand well above the end-year inflation
target; however, the target for end-2006 was not changed. Accordingly, the economic agents have
taken the inflation forecasts announced by the Central Bank for end-2006 as a point of reference
instead of the end-year inflation target for 2006. In fact, inflation expectations for end-2006 are in line
with the Central Bank's forecasts.
It is not something exceptional for the countries implementing inflation-targeting regime to experience
significant deviations from the inflation target. What matters most here is to be able to explain the
reasons for the deviation, to take necessary measures to ensure that the target could be attained
again and to inform the public of the convergence period. If the Central Bank had changed its inflation
target for end-2006 as 10 percent, it would have achieved the end-year target and would not have
been liable to be called to account to the public. However, instead of changing the target, the Central
Bank preferred to render account to foster its communication policy. Within this framework, the Central
Bank will inform the Government through a new open letter in January 2007 and explain the reasons
for overshooting the end-year inflation target, in addition to sharing its projections pertaining to the
convergence process with the public.
In conclusion, the Central Bank considers that frequent changes in targets are likely to have adverse
effects on inflation expectations and pricing behaviors, which could damage the credibility of the future
commitments. For this reason, it is important in the upcoming period that targets should be left intact
as long as inflation is expected to converge to targets within a reasonable period of time.
Transmission mechanism and control horizon
Central banks in both developed and developing countries experience serious uncertainties regarding
the lagged effects of monetary policy on inflation. Considering the fact that the relationship between
macroeconomic variables changed remarkably along with the structural transformation in the economy
after the 2001 crisis, it is assessed that the mentioned uncertainty in Turkey is at least as high as
those in other countries.
However, in light of the recent normalization experience, it is possible to produce forecasts about the
period required for monetary policy to influence inflation. The latest observations indicate that the
period needed for monetary policy measures to affect domestic demand varies between 3 to 9
months, while the change in demand influences inflation in a period between 3 months and 1 year.
This leads us to the conclusion that the impacts of monetary policy on inflation spread over a period of
one and a half years on average.
In this context, taking into account the lagged impacts of monetary policy, the Central Bank defined the
policy horizon as approximately one and a half years in the main policy statement published last year.
Although it is forecasted that the impact of monetary policy on inflation will show itself in a more lagged
manner and that the control horizon may be extended as the normalization process of the economy
continues, the control horizon is maintained as one and a half years at this stage. There is no doubt
that this period may be extended or shortened depending on the extent of shocks and the period
needed for their influence to reflect on prices. The impacts of various shocks on inflation may differ
according to time and period. As a consequence, the period required for inflation to converge to the
target again will be announced after the occurrence of shocks and the determination of their sources, if
there is a significant deviation from the target.
Forecast horizon
The forecasts presented in the Inflation Reports published throughout 2006, covered a period of one
and a half years. From 2007 onwards, forecasts will refer to a two-years period. This change aims to
help economic agents to predict the future better. Furthermore, forming a comparable forecast period
with the results of the Expectations Survey will provide us with the opportunity to analyze and assess
inflation forecasts more easily.1
Inflation forecasts and interest rate path
While producing inflation forecasts, one of the most critical questions to be answered is how the
monetary policy is shaped over the forecast horizon. Country experiences reveal that there are many
different approaches related to the presentation of forecasts and the method of signaling future
monetary policy. Accordingly, central banks can be classified into three groups:
(i) Countries in which central banks produce inflation forecasts by considering their own
potential policy responses: New Zealand, Norway, Canada, Sweden, Czech Republic,
Turkey, Columbia, Peru, Rumania. In addition, these countries announce their forecasts on
the interest rate path in verbal or numerical terms.
(ii) Countries where central banks employ the market expectations: European Union (European
Central Bank), Chile, Brazil, Czech Republic, Sweden, and England. In this framework, the
expected short-term interest rate path is calculated via the yield curve, expectations survey
and other sources and inflation forecasts are published under the assumption that this path
will materialize.
(iii) Countries in which central banks assume that interest rate will remain fixed over the forecast
horizon: England, Brazil, Peru, and Australia.2
In recent years, both academic literature and current central banking implementations increasingly
support the approach adopted by the first group, including Turkey for sharing the own expectations of
the central banks about future monetary policy with the public corresponds to the transparency and
predictability principles of inflation targeting. In this context, it is observed that more countries from
second and third groups join the first group each year.
Monetary policy and interest rate risk
As mentioned above, the Central Bank shares its forecasts about monetary policy verbally with the
public. When evaluating the inflation and monetary policy outlook, a particular question to be
answered is raised: How should the policy perspective that will keep inflation close to the target in the
medium-term (in a period of one and a half years to two years) be? The answers to this question as
provided in the Inflation Reports published in 2006 were as follows:
•
JANUARY 2006: "... a short-term interest rate path remaining constant for the first couple of
months in 2006 and displaying a gradual decline thereafter..."
• APRIL 2006: "...where the Central Bank continues to cut policy rates gradually..."
•
JULY 2006: "... in addition to the measures of June, the Central Bank will implement
measured monetary tightening in the rest of 2006 and cut policy rates gradually in 2007..."
• OCTOBER 2006: "under the scenario that the Central Bank maintains its tight stance until
the last quarter of 2007 and cuts policy interest rates afterwards..."
As it is clearly seen above, as long as there was not a significant shock in the economy, the Central
Bank acted in parallel to its earlier statements. However it had to revise its monetary policy stance
after important shocks such as the market volatilities of May and June. It is more evident in light of
these this example that, as it is frequently emphasized in our announcements, the interest rate path,
which is used by the Central Bank in producing forecasts, should not be perceived as a commitment to
be followed in every case. Hence, the interest rate risk should be assessed by considering the fact that
the outlook presented in the Inflation Report is subject to change depending on the data flow, and
thus, the policy perspective can be updated whenever necessary. Since the end of 2005, the Central
Bank has repeatedly drawn attention to this matter via the Inflation Report and other policy documents.
Special CPI aggregates and core inflation
Instead of considering a single so-called core indicator, the Central Bank uses more than one indicator
in the differentiation of various exogenous shocks. Thus, depending on the source of shocks, different
indicators may stand out from time to time. For instance, the index that excludes the energy item in a
period where oil prices display high increases or the index that excludes the unprocessed food group
in a period where agricultural prices fluctuate excessively may contain more comprehensive
information in order to achieve a better understanding of the main inflation trend.
Special CPI aggregates produced will continue to be a part of the forward-looking inflation analysis
and the communication policy of the Central Bank. As of 2005, TURKSTAT started to publish 7 special
CPI aggregates and beginning from September 2006 the H index composed by excluding energy,
alcoholic beverages-tobacco, unprocessed food, and gold has started to be published. Currently, even
though the H index seems to be relatively in the forefront, it should be kept in mind that this index is
sensitive to developments in FX rates and it could provide incomplete information in periods when FX
rates are highly volatile. In such periods it would be appropriate to support the data from the H index
with other indexes that have low FX rate pass-through (for example; evaluating them with service
prices inflation).
Hence, the Central Bank will not use only one indicator to assess the main trend in inflation and will
openly inform the public of the type of the relevant indicator and the degree of its importance.
Moreover, after reaching a satisfactory number of observations, new indices can be compiled based
on different techniques and the SCA can be updated.
Public sector's role in the inflation targeting regime
In the inflation-targeting regime, developments in the public sector are a matter of concern from the
monetary policy perspective. The CBRT certainly cannot control polices implemented by the public
sector. However, the fact that the size of the public sector relative to the economy is still large makes it
necessary to closely monitor the developments in this area. In accordance with its law, a central bank,
which focuses on price stability, has to monitor developments in budget and fiscal policy and has to
react to the possible repercussions of these policies on inflation.
Policies of the public sector have the potential to affect the inflation outlook through various channels.
The first channel comprises expectations. Further enhancement of fiscal discipline through its
continuity will increase the effectiveness and predictability of monetary policy by extending the
borrowing maturities and reducing risk premiums and the volatilities in risk premiums and facilitate the
management of inflation expectations.
Pricing behavior of goods and services produced or controlled by the public sector itself or the indirect
taxation channel has a direct effect on inflation. In this framework, pricing goods and services
produced by the public sector rationally and enhancing the quality of fiscal discipline is crucial in terms
of the predictability of inflation.
Another channel, which affects inflation and inflation expectations, is the incomes policy of the public
sector. One of the main determinants of expectations for price and wage inflation in Turkey is the
increase in wages made by the public sector to its own employees. Wage increases in the public
sector may set a precedent for the private sector. In this context, the consistent trend of the incomes
policy with the inflation target is significant in terms of achieving the inflation-targets more easily and
quickly.
One of the main components of total demand is the public sector's direct purchase of goods and
services. Therefore, while evaluating developments regarding the inflation outlook, the Central Bank
carefully monitors public expenditures as well.
The Central Bank takes into consideration the budget projections while setting the inflation targets and
the monetary policy perspective and hence, makes various assumptions regarding the channels
mentioned above. In case of an unpredicted development in one of the channels, the policy stance
needs to be updated.
Monetary Policy Committee meetings and the decision-making process
The Monetary Policy Committee will continue to meet once a month in the upcoming period as it has
done since 2001 and as stipulated by Central Bank Law. The meeting will continue to be held in two
sessions. The first session will start at 1:00 pm and will host the Central Bank authorities and
specialists as well as authorities from the Undersecretariat of Treasury. In this session, the related
bodies of the Central Bank will present their reports on evaluations about economic developments and
inflation outlook to the Monetary Policy Committee. At the same time, the authorities from the
Undersecretariat of Treasury will present their evaluations on the developments in debt management
and fiscal policy to the Committee. In the second session, the Committee members will make the final
evaluations about the outlook and the decision will be put to a vote. After making a decision, members
of the Committee will prepare a brief report explaining the rationale of the decision. The decision and
its rationale will be announced by the Central Bank in a press release before 7:00 pm on the same
day, and it will also be posted on the website of the Bank. A significant change in the upcoming period
is that the Turkish version and the English translation of the decision will be published on the same
day.
Other policy statements and important dates
The Central Bank will continue to publish main policy statements regularly in 2007 as well. Within this
framework:
•
The Inflation Report will continue to be published quarterly.
•
The Financial Stability Report will be published twice a year on previously announced dates.
•
The statement entitled Summary of the Monetary Policy Committee Discussions will be
8 working days Summary of the Monetary
published within following the meeting with the title
Policy Committee Meeting, alongside its English translation.
•
As of July 2006 the "Price Developments" report started to be published to provide an
accurate understanding of inflation data. This report will be published within 2 working days
following the announcement of inflation data.
•
Besides all these statements, presentations and speeches made by the Governor and the
Committee members will be shared with the public from time to time.
• Moreover, the research papers, booklets, and technical notes published by the Central Bank
and organized conferences will continue to be a part of the communication policy.
The publication calendar for the Inflation Report and the Financial Stability Report along with the
Monetary Policy Committee Meeting dates are presented in the Appendix. Meeting dates have been
determined by taking into account such factors as official holidays, national and religious festivals, and
the data flow calendar.
Exchange rate policy and foreign exchange buying auctions
Along with inflation targeting, the Central Bank will continue to implement a floating exchange rate
regime in the upcoming period. In the floating exchange rate regime the FX rate is neither a target, nor
a policy tool. The only variable that the Central Bank sets as target is inflation and the main policy tool
to achieve this target is short-term interest rates. Therefore, the Central Bank targeting a variable such
as FX rate, growth or current account deficit is out of the question.
The Central Bank shares with the public the general framework of the current exchange rate policy
and FX buying auctions in the press releases it has issued each year since the start of 2002. As also
stated in these press releases;
(i) In the current floating exchange rate regime, exchange rates are determined by supply and
demand conditions in the market and the Central Bank does not have any exchange rate
target.
(ii) Since there is no exchange rate level to maintain in countries with floating exchange rate
regimes, the level of foreign currency reserves is much less significant compared to
countries with fixed or flexible exchange rate regimes. However, especially in emerging
economies such as Turkey, a strong FX reserves position is significant in removing the
unfavorable effects of potential internal and external shocks and boosting confidence in the
country's economy. In addition, taking into account the foreign debt payments of the
Treasury and the need to gradually reduce the number of high-cost remittance accounts in
the long-term, which are peculiar to Turkey and make up a significant part of the liabilities
side of the Central Bank's balance sheet, the Central Bank holds foreign exchange buying
auctions to build up reserves at times where foreign exchange supply constantly increases
compared to foreign exchange demand.
(iii) The economic transformation process experienced after the 2001 crisis has enabled
significant achievements in macroeconomic stabilization and helped reduce the
"dollarization" effect created by unstable macroeconomic policies and high inflation in the
past. Despite some deviations from this main tendency due to exogenous shocks and
changes in risk perceptions, decisive implementation of economic program has always
enabled a return to the main tendency. This process, combined with favorable developments
in the balance of payments, has supported the increase in foreign exchange supply in the
economy.
(iv) In this framework, in order to minimize the impact on supply and demand conditions in the
foreign exchange market, the Central Bank, which follows a moderate reserve-raising policy,
has conducted its FX buying via auctions, whose terms and conditions are announced with
due notice, since 1 April 2002. Moreover, the Bank has announced annual auction programs
since 2005 and does not make any amendments to these programs, unless extraordinary
differences are observed in foreign exchange liquidity.
(v) Meanwhile, as also emphasized in all its press releases, the Central Bank will continue to
closely monitor the volatility in exchange rates and may directly intervene in the markets in
the event of excessive volatility that might occur in either direction. These volatility
interventions are not only carried out by considering past data with a mechanical rule, but by
evaluating all aspects of realized and potential volatilities.
In the press release referred to as "The General Framework of Inflation Targeting Regime and
Monetary and Exchange Rate Policy for 2006" dated 5 December 2005, the annual auction program
for 2006 was announced in consistence with the aforementioned general framework. The maximum
daily amount that can be bought was determined as USD 60 million, with USD 20 million of auction
amount and USD 40 million of optional selling amount (200 % of the total amount sold), to be effective
as of the 2nd of January 2006.
However, in line with the decline in foreign exchange supply due to global liquidity conditions, the
depth of the foreign exchange market was lost and volatilities were observed in exchange rates.
Therefore, the Bank decided to suspend daily FX buying auctions for a certain period of time, starting
from the 16th of May 2006.
Moreover, as a response to the excessive volatility in exchange rates observed in 2006, the Central
Bank directly intervened in the market via one FX buying intervention and three FX selling
interventions. These interventions were as follows:
(i) Following the increase in foreign exchange sales due to developments in international
markets, the Central Bank decided to directly intervene in the market by buying a total
amount of USD 5.4 billion foreign currency on 15 February 2006, in order to prevent actual
and expected excessive volatilities.
(ii) On 13 June 2006 and 23 June 2006, the Central Bank decided to directly intervene in the
market by selling foreign currency in order to prevent the excessive volatility observed in line
with the liquidity shortage in the foreign currency market due to global liquidity conditions.
Total amounts sold were USD 0.5 billion and USD 0.8 billion, respectively.
(iii) In the Monetary Policy Committee meeting held on the 25th of June 2006 following the
aforementioned interventions, it was stated that the liquidity shortage in the foreign currency
market continued and once again underlined that an effective foreign currency market was a
prerequisite for the price stability target. Thus, in order to provide foreign currency supply via
its instruments and mechanisms, the Central Bank directly intervened in the market by
selling an amount of USD 0.9 billion foreign currency on the 26th of June 2006. In addition to
this intervention, two more FX selling auctions were held on the 26th and 27th of June 2006,
in which a total amount of USD 1 billion foreign currency was sold.
Following the measures taken by the Central Bank against the volatility in financial markets in May and
June 2006 and improved global liquidity conditions, the foreign exchange market has become
relatively stable. For this reason, the Central Bank has decided to resume the foreign exchange buying
auctions, which were suspended on the 16th of May 2006, as of the 10th of November 2006.
Accordingly, the maximum daily amount to be purchased in the auctions has been set at USD 45
million, with USD 15 million for auction amount, and USD 30 million for optional selling amount (200 %
of the total amount sold).
As of 12 December 2006, the total amount of foreign currency purchased via auctions and
interventions is USD 9.4 billion, while the total amount sold is USD 3.1 billion for the whole of 2006.
The total amounts of foreign currency purchased and sold by the Central Bank are shown year by year
in the table below:
Table 2: The Central Bank's net foreign exchange purchases and sales (2002-2006; million
USD)
FX Buying FX Selling FX Buying FX Selling Total Net FX
Year
Auctions Auctions Interventions Interventions Buying
2002 795 - 16 12 799
2003 5.652 - 4.229 - 9.881
2004 4.104 - 1.283 9 5.378
2005 7.442 - 14.565 - 22.007
2006* 3.961 1.000 5.441 2.105 6.297
Total 21.954 1.000 25.534 2.126 44.362
Unless extraordinary differences are observed in foreign exchange liquidity conditions, FX buying
auctions will continue in 2007 in the framework of the aforementioned program. However, as was the
case before, the Central Bank may, with prior notice, suspend the auctions temporarily for short or
longer periods when the depth of the foreign exchange market is lost due to exogenous shocks or
unforeseen extraordinary developments, and when the resulting excessive volatility and unhealthy
price formation are observed in foreign exchange rates. On the other hand, the Central Bank will
continue to closely monitor the volatility in exchange rates also in 2007 and will directly intervene in the
market in the event of actual and potential excessive volatilities.
Banks will be able to borrow foreign exchange in terms of USD and euro from the Central Bank within
the predetermined limits with a one-week maturity in the Foreign Exchange and Banknotes
MarketForeign Exchange Deposit Market in the upcoming period too. Moreover, the purchase/sale
transactions of "foreign exchange against foreign exchange", "foreign exchange against foreign
banknotes" and "foreign banknotes against foreign banknotes" conducted between the Central Bank
and institutions authorized to operate in the Foreign Exchange and Banknotes Markets will continue.
In conclusion, as can be understood from the general framework and our exchange rate policy
implementations described above, exchange rates are established by supply and demand conditions
in the foreign exchange markets under the implementation of the floating foreign exchange regime.
The key determinants of foreign exchange supply and demand are the monetary and fiscal policies
and the economic fundamentals determined by the structural reform process and expectations. It
should be borne in mind that in a floating exchange rate regime, economic agents operate in an
environment of exchange rate risk. Nevertheless, as repeatedly emphasized by the Central Bank,
exchange rate risk is a manageable risk and economic agents should establish the mechanisms that
will ensure the efficient management of this risk.
Liquidity management
Excess liquidity, which was created by the Central Bank's purchases of government securities worth of
YTL 14 billion from state-owned banks and banks transferred to the Savings Deposit Insurance Fund
(SDIF) in order to meet their liquidity needs following the February 2001 crisis, as well as the intensive
foreign exchange purchases during the 2003-2005 period, persisted in 2006.
The Central Bank, withdrew the excess liquidity in the market mainly via New Turkish Lira deposit
operations in the Interbank Money Market within the CBRT and Repo transactions in the Repo and
Reverse Repo Market of the Istanbul Stock Exchange, on an overnight basis. Accordingly, overnight
interest rates were constantly realized around the borrowing rate of the Central Bank. Hence, the
borrowing rate of the Central Bank has continued to be an indicator for money markets.
Based on the information currently available, the level of the liquidity in the market in 2007
(i) The increase in base money,
(ii) Coupon and principal redemption by the Treasury to the Central Bank,
(iii) Treasury's foreign exchange debt payments financed by its domestic currency borrowing
will have a lowering effect, while
(i) The Central Bank's net foreign exchange purchases,
(ii) Interest payments to be made by the Central Bank for reserve requirements and for excess
liquidity absorbing transactions,
(iii) The decline in Treasury cash accounts with the Central Bank will have an increasing effect
on liquidity.
Based on the assumption that the foreign exchange payments of the Treasury would exceed the
foreign exchange inflow, and by taking the Central Bank FX buying auction program into
consideration, the excess liquidity in the market is expected to continue within reasonable limits in
2007, even though temporary liquidity shortages may