Turkish Economic Policy Research Foundation (TEPAV) issued a note on Turkey’s inflation and monetary policy path. The group called on the central bank to hike the policy rate to 47,5 percent from the current 45,00 percent.
Turkey’s 6.7 percent monthly inflation in January 2024 is higher than the annual inflation in the same month for 17 members of the G20. Argentina and Turkey differ markedly from other G20 countries in terms of both the current level of inflation and its monthly increase.
In our previous assessments, we have underlined that the current economic program has two main problems to solve in order to achieve its short-term objectives: to put growth on a sustainable path and to reduce inflation, interest rates and the risk premium. The first of these was that the financing need arising from the current account deficit was not being met through normal channels. The most recent balance of payments data is for December 2023 points to partially positive developments in the last seven months of 2023 in terms of financing.
The second main problem was the possibility that both pre-election expenditures and earthquake expenditures would lead to high levels of budget deficit. The ratio of the 2023 Central Government budget deficit to the 2023 GDP targeted in the MTP is around 5.4 percent. January realizations also show that spending pressures continue to be intense. Our studies at TEPAV suggest that the deterioration in the budget deficit and debt stock may continue unless additional measures are taken.
In our previous notes, we emphasized that the main problem for monetary policy is how to reduce inflation, which is expected to peak at around 75 percent in May 2024, to 36 percent by the end of 2024 and how to maintain this downward trend in the following period. Today, there are three other developments that deepen this fundamental problem.
First, the gap between the 2023 central government budget and the 2023 central government cash budget has reached unprecedented levels. Expenditures that were accrued but not converted into cash expenditures suddenly became visible in December 2023. In fact, the central government’s cash budget deficit significantly exceeded the budget deficit in January. If the remaining cash disbursements are mostly made in early 2024 in a way to increase the volume of liquidity, the liquidity surplus that has been in the system for some time will further increase and the fight against inflation will become more difficult.
Second, the average inflation expectation for end-2024 is still as high as 43 percent. Moreover, the high level of monthly inflation in January may have a negative impact on February inflation, further distorting inflation expectations.
The third is the possible inflationary impact of fiscal measures to reduce the budget deficit, which is expected above 6 percent of GDP in 2024. As stated in the Central Bank’s inflation reports, the SCT and VAT-dominated tax adjustments in 2023 are among the factors pushing inflation upwards. As we have stated before, public expenditures and the tax base should be revised in a way that takes into account efficiency, social welfare and inflation.
In light of the available information, external conditions are favorable for achieving the end-2024 inflation target. The average Brent crude oil price in 2024 is expected to be no different from the 2023 average. Major central banks such as the Fed and the ECB are expected to begin the process of lowering policy rates. These two developments will be beneficial for the current account deficit on the one hand and for the financing of the deficit and exchange rate increases on the other. However, the ongoing tensions in the Red Sea may also have negative effects in this context.
What to do?
In order to combat inflation, the downtrend in the risk premium should be permanent and the limited real appreciation of the Turkish lira should continue for a while. To this end, measures to reduce the budget deficit and the tightening in monetary policy should be maintained in the upcoming period. In addition, the government’s decisions regarding administered and administered prices should be supportive of the inflation target. In sum, the “Economic Rationalization Program” should be implemented with determination and the perception that there will be no going back from this program should be strengthened and disseminated.
Moreover, the program should be supported with new steps. In addition to policies to ensure macroeconomic stability, it is important to implement structural reforms that will make institutions – such as the CBRT and TurkStat – independent, increase productivity, accelerate the green transformation process, improve the quality of education, and establish a fair and fast legal system. It should be emphasized once again that such structural reforms will facilitate the achievement of macroeconomic stability and increase the likelihood that such stability will be permanent.
At the January MPC meeting, the policy rate – the repo rate – was raised to 45 percent. However, the increase in the policy rate was not reflected in Turkish lira deposit rates to the extent that it would both significantly reduce residents’ demand for foreign exchange and lower the rate of increase in consumption expenditures.
One of the main reasons for this situation is that the Central Bank felt the need to increase its foreign exchange reserves, albeit on a gross basis, and realized Turkish lira swap transactions against foreign exchange. The second reason is the payments made by the Central Bank due to Turkish lira currency-protected deposits. The third, as mentioned in our previous assessment note, is the potential for a liquidity surplus due to the realization of a cash budget deficit equal to the accrued budget deficit. This effect was observed to some extent in January. There is a possibility that this could be done in a liquidity-enhancing manner – for instance, by the Treasury reducing its deposit account at the Central Bank. Moreover, ‘attractive’ opportunities for banks, such as depositing Turkish lira-denominated funds received through swap transactions at an interest rate below the repo rate of a few months ago at higher interest rates or lending them overnight to the Central Bank, also have the potential to increase liquidity.
In the absence of a strengthening of the Return to Rationality Program and the elimination of doubts about its continuation, foreign exchange reserves cannot be increased naturally. Therefore, deposit rates do not adjust sufficiently to the policy rate and the monetary transmission mechanism does not function properly.
Conclusion
In light of these considerations, the repo rate should be raised to 47.5 percent and it should be indicated that further tightening may be implemented depending on the data.
The implementation of Turkish lira swap market transactions against foreign exchange should be reviewed; the maturity of these transactions should be gradually shortened, and the amount of these transactions should be reduced.
In our previous assessments, we emphasized the importance of announcing an official inflation target for each year-end of the 2024-2026 period. This would be an important communication policy tool to quickly close the Central Bank’s credibility gap.