Simplification carrot for Turkey’s ‘not-so-tight’ monetary policy

Deputy Prime Minister Mehmet Şimşek, who appeared on broadcaster NTV for an interview on April 30, just before Central Bank chair Murat Çekinkaya’s presentation on the latest inflation report, made some interesting comments.

“Inflation is down by 1.7 points compared to the end of 2017. We had expected a larger decline in inflation and we did not foresee such a sharp decline in the value of the Turkish Lira. The underlying problem here is the currency. Inflation has not come down to single-digits because of the speedy decline in the value of the lira,” Şimşek said.

Indeed, that is the main problem. There are policymakers who set the inflation target at 5 percent but failed to devise the necessary policies to meet that target and now make excuses when inflation has missed the target and has not even dropped to “single-digits.” Thus, when people lose their confidence in policymakers and individuals and companies choose to take foreign currencies, those same policymakers come out and say “we had not anticipated such a sharp decline in the value of the lira.”

In January, the Central Bank said that “given a tight policy stance focused on bringing down inflation, inflation is projected to converge to the 5-percent over target gradually, and mid-point inflation would be 7.9 percent at the end of 2018.” But on April 30, the Central Bank announced that it lifted the end-2018 inflation forecast to 8.4 percent.

So, are you really implementing tight policies? Nobody believes this. People expect inflation to be “twice the inflation target.” According to the Central Bank’s own expectations survey, respondents forecast inflation to be at 10.07 percent by the end of this year, 9.62 percent at the end of next year, and 8.63 percent at the end of 2020. The yield of two-year bonds is at 14.30 percent. So the bond market just shrugs off the 0.75-basis point rate hike and inflation expectations.

This is a Central Bank that in fact is not implementing tight policies but wants us to believe its policies are “tight.” It is a Central Bank that is manifestly failing to control inflation but it still keeps telling stories.

The latest story – in fact the new “carrot” - that it told on April 30 is that a “simplification” of monetary policy will take place soon. When people attending the briefing on the inflation report demanded details, the Bank just said this simplification will happen “very soon” but the authorities have not yet decided about its framework.

Recall that the previous “simplification process” focused on lowering interest rates. As a result, what the authorities announced is not “normalization” and is not credible. “When it comes to the operational framework, when we talk about the simplification steps taken by central banks, you expect a single, a final step. However, central banks have different approaches toward the operational framework,” Çetinkaya said, thus apparently burying the “carrot.”

What needs to be done is obvious, but the “operational framework” will serve as an escape ramp that will water down the entire process.

How to implement the simplification?

Given the current level of interest rates, simplification should take the following form: The Central Bank funds the markets at a rate of 13.50 percent through the Late Liquidity Window. However, it should do this via the one-week repo with 8 percent interest rate, which is a tool that the Central Bank does not use at the moment. And the Bank must lift the one-week repo rate to 13.50 percent.

If the current interest rate mechanisms and operational frameworks are simplified, the banking sector’s liquidity needs should be met through one-week repo and at the rate of 13.5 percent. In exceptional cases the liquidity should be provided through overnight lending in the interbank market, and the interest rate of this window must be higher than the one-week repo rate. This overnight rate must be lifted to 14.50 percent from current 9.25 pct. The late liquidity window should be higher than this and the late liquidity window rate must hiked to 16.5 percent, because this is a window that is ringing alarm bells.

The Central Bank should lift the interest rate for borrowing from banks with excess liquidity to 12.5 percent (from the current 7.25 percent), thus setting a floor rate to ensure a stable lira. This will end the practice of withdrawing money with swap transactions at the rate of 13.50 percent.

Under this scheme, the markets will be funded through the overnight rate in the range of 12.5-14.5 percent and the 13.5 percent one-week repo rate.

Given the existing indicators, those interest rates are not tight enough. But they do give some idea about how the simplification process should be carried out within the framework of actual funding rates.