Inflation and growth

The relationship between inflation and growth is one of the issues which has been extensively studied in economics literature. Until a few years ago, this subject frequently came onto the agenda in Turkey. Particularly in periods when stabilization programs were applied to try to reduce inflation, as soon as the first problems arose in the economy there were calls to “Forget inflation, look at growth”.

There was a similar debate in early 2002 at the beginning of the process which resulted in inflation falling to single figures and which we discussed at the time in Conjuncture. In that article we drew attention to the fact there is a negative relationship between inflation and growth; that is to say that high inflation reduces growth. For this reason, even though economic circles at the time were worried that that there would be no growth, we supported the struggle against inflation.

When conditions change…
Four years ago inflation was over 70 percent and, when it was at that level, there was little chance that the struggle that was launched against inflation would harm growth. In fact, this is how things turned out. In the last four years inflation has fallen rapidly and Turkey has equaled the record for 1950-1953, when the economy grew rapidly for four years in a row. Today inflation stands at 7 percent. We think that from now on there is a possibility that the struggle against inflation will harm prospects for growth. For this reason, we are of the opinion that, in addition to fighting against inflation, we must also safeguard growth. Because we need rapid growth in order to reduce unemployment, which has today become the leading problem in the country.

Let’s state first of all that our belief that there is a negative relationship between inflation and growth is stronger today than it was four years ago. Inflation has been falling over the last four years, while growth has risen rapidly; which means that a large proportion of those who are follow economics are now convinced that there is a negative relationship between inflation and growth.

But the studies we have made have shown that the relationship between inflation and growth is not consistent. To put it more clearly, inflation begins to have a negative impact on growth only after a certain threshold value has been exceeded. If it is below this threshold value, then inflation and growth run in parallel. That means that when the rate of inflation is low and inflation falls still further then it reduces the rate of growth and that growth accelerates together with a rise in inflation.

What is the threshold in Turkey?
We tried to determine whether there is or is not a threshold effect in the relationship between inflation and growth in Turkey by analyzing the data for the period 1950-2005. Our analysis showed that in Turkey the threshold for a chance in the relationship between inflation and growth is 6 percent. In years when inflation fell to less than 6 percent then this relationship became positive.

At the moment inflation in Turkey is 7.9 percent. The target for the end of 2006 is 5 percent. That means that in order to attain this target it must fall beneath the threshold value we identified in the analysis we conducted above.

After the 2001 crisis the Central Bank began to assume virtually all of the responsibility for the struggle against inflation and in the last four years it has concentrated solely on inflation. As it has said itself in various reports and statements, during this period the Central Bank’s sole goal has been to reduce inflation. After the crisis the short-term interest rates, which were identified as the primary instrument of monetary policy, were used solely to achieve the targets for inflation. During this period, while inflation was falling, the economy continued to grow strongly; which confirmed that the policy pursued was correct.

But, in order to reach the target that has been set, this year inflation will have to fall below the threshold level; which means that it does not look as if the same policy should be pursued. Because in such a situation there is a chance that economic growth will decline together with inflation.

Rapid growth is essential
In fact, for Turkey rapid economic growth is now more important than reducing inflation still further. Four years ago our main problem was inflation; now it is unemployment. The most important prerequisite for reducing unemployment is continued growth.

The public feels the problem of unemployment more than that of inflation. It is a reality that inflation reduces growth but it is not very easy for anyone except an  expert to understand this. In fact, this is why for a long time there was no serious struggle against inflation. The impact of unemployment was so clear that no need was felt to explain it. The number of unemployed rose from 1.5 million to 2.5 million after the crisis and is still at the same level. Turkey has a young population and approximately 500,000 people enter the labour market each year, which means that there is a possibility of the number of unemployed being swollen still further.

Research has shown that a growth rate of 6 percent is required just in order to create employment for the young people who enter the labour market each year. If the number of unemployed is to be reduced from its current level, then growth must be even higher.

It is now time to concentrate on growth
2.5 million unemployed is already a high number for Turkey. Calculations of the rate of the unemployed to the labour force shows that unemployment is close to 10 percent. As there will always be those who have left jobs and those who are looking for work, it is impossible to reduce this figure to zero but it needs to be reduced to less than 5 percent. If not, there will always be a lot of tension in society. It will become impossible to reduce the increasingly rising crime rate.

This is why we think that it is now time to focus not just on inflation but on ensuring growth. Four years ago we definitely had to reduce inflation in order to secure stable growth. Now we are in a position where, in order to ensure sustained growth, we need to make concessions on the issue of inflation.

Indeed, it looks as though the Central Bank has made just such a change in its monetary policy this year. Over the last four years the Central Bank has concentrated only on inflation but in its first ‘Inflation Report’ of the year, which was published in January, there are indications that it will now also focus on growth. We think that this change in policy is correct.

THE FIRST OF THE MAASTRICHT CRITERIA IS OK
In 1991, at a meeting in the Dutch city of Maastricht, the European Union (EU) set criteria for the countries which were going to enter monetary union. In later years these have become universal criteria from the point of view of ensuring a strong economy. We are still far from meeting the criteria for inflation. The situation as regards the public debt is unclear as it depends whether one looks at the net or the gross debt. But we achieved the criteria for the budget balance last year. While even Germany and France, the locomotives of the EU, are still struggling to comply with these criteria.

The Maastricht criteria for the budget balance proposes that the deficit should not be more than 3 percent of national income. The budgetary data for 2005, which were released by the Ministry of Finance last month, show that in Turkey this rate has fallen to 2 percent.

Following the decline in interest payments as a result of the stability which has been largely established in the economy, our budget deficit declined by 67.8 percent last year compared with 2004 to YTL 9.7 billion. The figure for national income in 2005 has yet to be announced but it looks as though it will be around YTL 490 billion. This means that the budget deficit will be 2 percent of national income.

Four years ago the rate of the budget deficit to national income in Turkey was 16.9 percent. Being able to reduce this rate to under the Maastricht in a period as short as four years is an indication of the success of the stabilization programme that was applied.