Falling Turkish inflation opens debate on monetary policy

By bne IntelliNews July 9, 2012

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With signs that the central bank may yet see inflation meet its ambitious year-end target of 5%, the market is speculating that the sharp drop in Turkish price growth in June could lead to an interest rate cut, especially given disappointing growth figures recently.

Some analysts say they now anticipate a cut in interest rates, perhaps as early as the third quarter, whilst others insist that the country's huge current account deficit, exposure to external debt markets and consequent vulnerability of the lira will likely stay the Central Bank of Turkey's (CBT) hand and keep policy tight.

The market welcomed inflation figures released last week that easily beat expectations, continuing the slowdown in price rises which has brought the headline inflation figure down to 8.9% and core inflation to 7.4%. And many expect the trend to continue.

As Neil Shearing at Capital Economics puts it: "Looking ahead, both we and the CBRT expect inflation to fall further as the effect of last year's spike in global energy prices as well as increases in local utility tariffs starts to unwind. The fall will be particularly pronounced by around October and we think it could drop to just above the CBRT's central target of 5.5% by the end of the year (a much sharper slowdown than the Bank itself expects)."

Added to a first-quarter GDP contraction of 0.4% quarter on quarter, many feel this will convince the CBRT to lower rates.

Whilst forecasting a potential cut, Mert Yildiz of Renaissance Capital points out in a note that it would likely prove a short-term move, and that inflation will struggle to continue to fade in the medium term. "With inflation on a downward path, we believe the CBRT's focus will switch to promoting growth; hence we think the CBRT will keep monetary policy relatively loose in the second half (despite recent rhetoric suggesting otherwise) and ease short-term rates via lira liquidity... We may see even lower rates in [the third quarter] as the CBRT could be anticipating very low year-end inflation."

However, Shearing writes: "Growing speculation that the CBRT will respond by loosening policy overlooks a crucial point: the current account deficit, while narrowing, is still around 9% of GDP. This implies there is little room to further boost domestic demand."

In addition, Turkey's clear vulnerability to events in the Eurozone compound the point, he says. "In addition to its sheer size, the funding of the current account deficit is also a concern for policymakers. As things stand, almost 80% of the deficit is financed by inflows to the bond and equity markets, as well to Turkish banks. These tend to be more volatile forms of funding. By contrast, foreign direct investment (which tends to be more stable) covers just over 20% of the deficit."

"Should the euro-crisis escalate along the lines we envisage (our central assumption is of a limited form of break-up commencing this year) then the associated financial market dislocation would threaten a sudden stop in capital flows to Turkey. This in turn would trigger a fresh fall in the lira, thus requiring the CBRT to keep policy tight."

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