Turkish central bank's credibility on the line

Turkish central bank's credibility on the line
By Kivanc Dundar in Istanbul January 7, 2016

The worsening of Turkey’s inflation outlook, together with the volatile global market environment, will put the country’s central bank under pressure to raise interest rates this year, at a time when politicians are demanding a cut in rates.

Turkey's annual inflation overshot its target for a fifth year running in 2015, putting pressure on the central bank to put up rates. It looks like inflation will remain one of the main challenges for the economy and continue to trouble Turkey’s central bank in the new year.

Consumer prices rose 8.81% year-on-year in December. This was above the central bank's 5% target, and its revised forecast of 7.9% for end-2015. The depreciation of the lira by around 20% against the dollar last year and an annual rise of 10.87% in food prices were the main factors behind the disappointing inflation figure.

According to data of the statistics office TUIK, consumer prices increased by 0.21% m/m in December against the market consensus forecast of a decline of 0.04% m/m. Food prices rose by 1.24% m/m in the month, adding 0.3 percentage point to headline inflation. Fruit and vegetable prices had been expected to decline as the Russian sanctions could have led to a supply glut at home. But this expectation did not materialise: the price of fresh fruit and vegetable surged by 3.75% m/m in the month.

Following the downing of a Russian bomber near the Syrian border by a Turkish jet in November, Moscow has imposed a raft of economic sanctions on Turkey, including a ban on import of fruit and vegetables. Local companies have turned to domestic markets to sell products that they cannot export to Russia.

Because of seasonal factors, clothing prices declined by 1.98% m/m, shaving off 0.15 percentage point. Reflecting the positive effects of lower energy prices, transport costs fell by 0.57% m/m in December, subtracting another 0.09 percentage point from headline inflation. Housing prices showed a 0.43% m/m increase, adding 0.07 percentage point to inflation.

The main core indices were also troubling. The rise in the so-called I-index – one of the bank’s favourite core inflation indicators that excludes food and beverages, energy, tobacco products and gold – quickened to 9.51% y/y in December from 9.22% in November.

More troubles ahead

Deputy Prime Minister Mehmet Simsek admits that battling inflation will be this year’s main economic challenge. But the recently announced sharp minimum wage hike and administrative price hikes will push inflation up further, making the central bank’s job even harder.

As part of its election promises, the government has increased the minimum wage by 30% to TRY 1,300 (€407) as of January 1 to boost domestic demand. The impact of this wage hike on inflation could be between 1.1-2.2%, according to Simsek.

“The minimum wage hike as well as a series of administrative price hikes announced in the first days of the new year have forced us to revise our end-2016 inflation forecast to 8.1%,” said J.P. Morgan in a report, published on January 4. “As the impact of the administrative price hikes will be immediate and the impact of the minimum wage hike will be relatively fast, we see yearly inflation climbing to 9.5% in the next three months.”

The government has raised taxes on alcohol products by between 12% and 15% for 2016. The minimum fixed tax rate on cigarettes was increased by 5% and the energy market regulator EPDK raised electricity prices by 6% for the first quarter.

The central bank calculates that the recent hikes in administered prices will add 0.7 percentage points to inflation.

The bank’s initial CPI inflation forecast for 2016 was 6.5% and this projection only included the minimum wage hike.

Given that demand conditions are improving and the accumulated impact of exchange rate depreciation continues, the first couple of months in 2016 are likely to have above 9% [inflation] rates, according to Deniz Invest.

“We expect inflationary pressures to remain intact in the upcoming months due mainly to the lagging effect of FX pass-through and gradual fading effects of lower energy prices,” says Morgan Stanley analyst Ercan Erguzel.

Pressure to raise and cut rates

The tight monetary policy stance will be maintained until there is a marked improvement in the inflation outlook, central bank governor Erdem Basci said in a presentation he delivered to the members of the cabinet on January 4. The bank may start to simplify its monetary policy from its next rate-setting meeting only if there is a decline in global volatility, he added. The next monetary policy committee (MPC) meeting will take place on January 19.

Deniz Invest, a local brokerage house, predicts that volatile market conditions, especially after escalated geopolitical risks, may prompt the central bank to remain on hold at the next MPC meeting.

Many analysts argue the central bank needs to act fast to tighten policy, rather than relax it, given the pressures on the lira from the volatile global market environment.

“The central bank needs to act more prudently than before. We are yet to see any signs/announcements by the central bank towards that end. Given that the term of Basci ends in April, we see a slim chance that the central bank acts with vigour,” said Yarkin Cebeci, an economist at J.P. Morgan, in a report published on January 4. Cebeci expects the central bank to start normalisation by hiking the lower band of the interest rate corridor and the policy rate by 50bp this month. “We still fear that the central bank will remain behind the curve, leaving Turkey vulnerable to shifts in global risk appetite,” Cebeci added.

In a surprise move, the central bank left interest rates unchanged in December for a tenth straight month. It kept its main policy rate (one-week repo) at 7.5%. The bank did not change the overnight borrowing rate and lending rates, holding them at 7.25% and 10.75%, respectively.

But if the growth outlook deteriorates, the central bank could come under pressure from politicians to cut rates to stimulate economic activity to create a “feel good” factor when the ruling Justice and Development Party (AKP) holds a referendum on a new constitution to give President Recep Tayyip Erdogan more executive powers. Erdogan, the country’s most powerful figure, once said: “Defending high interest rates is tantamount to treason”.

The new AKP government has announced an action plan aimed at stimulating domestic consumption. As part of its elections promises, the ruling party promised higher pensions, and said it would remove the VAT on fertilisers for farmers. Owners of small businesses will be also exempt from income tax for up to TRY8,000 (€2,500) of their annual revenue.

If the bank caves in to the political pressure, its credibility could be undermined. The lira was one of the worst performing emerging market currencies last year and it remains under pressure. The lira sank to a three-month low of 3.0 against the dollar, a symbolic threshold, on January 6 due to negative global sentiment towards emerging markets, tensions between Saudi Arabia and Iran and domestic concerns about the central bank’s independence.

The central bank may have to raise interest rates at some point to defend the currency and prevent a potentially damaging capital flight. But Erdogan would not like this move and may once again lash out at the bank, reinforcing fears of political interference in the bank policy.

“If Erdogan/the AKP opt for populism over pragmatism on that crucial choice, Turkey’s vulnerabilities will magnify,” warned Capital Economics in a note, published on January 4.