Inflation Targeting

By the time our magazine has been published Turkey will have a new monetary policy system. The Turkish Central Bank will move to an inflation targeting regime from 1 January 2006.

Today, it is increasingly accepted that the primary purpose of monetary policy should be to secure and maintain price stability. Inflation targeting can be briefly defined as a monetary policy which is designed to secure and maintain price stability by setting a specific target for inflation, or target parameters for inflation, for a set period and is announced to the public.

Inflation targeting was first used in New Zealand in 1990. The interest in this application first began to rise rapidly towards the end of the 1990s. When Turkey is included, the number of countries which today apply an inflation targeting system in their monetary programme stands at 23. If we count Finland and Spain, which applied this system for a time before joining the European Monetary Union (EMU) at the beginning 1999, then the number of countries which to date have applied an inflation targeting regime stands at 25.

Prerequisites for success
It is possible to list the prerequisites for success in inflation targeting and the situation in Turkey as regards these prerequisites as follows:

• The first prerequisite is that the Central Bank must be autonomous or at least that nobody interferes in its operations. The law that was promulgated in May 2001 made the Turkish Central Bank (TCB) autonomous. Over the last four years the TCB has used this power and has not complied with everything the government has said.

• The second prerequisite is a declaration that the primary duty of the Central Bank is to secure price stability. This prerequisite was established by the law of May 2001.

• Another of the prerequisites for the successful application of inflation targeting is that the financial markets must be developed and have sufficient depth. The rate of money supply (M2) to Gross Domestic Product is the method usually used to measure financial development. When one looks at the situation in Turkey from this perspective then we are starting the application of inflation targeting at a slight disadvantage; because in developed countries the rate of M2/GDP is 75 percent while in Turkey the rate is 25 percent.

Pressure from the public sector is still a problem
• One of the prerequisites for the successful application of inflation targeting is that the markets should not be under pressure from the state. Turkey is at a disadvantage in this respect because over 90 percent of the securities that are issued on the financial markets are still government paper. But the private sector is slowly preparing to launch securities. When the private sector begins to launch securities the prevailing disadvantage in this area will be ameliorated to a certain extent.
• In order for inflation targeting to be successful there should not be any problems in public financing. In 2001 the situation in Turkey was not good in this regard as state revenues had difficulty meeting even interest payments. The situation is better today. If the targets are attained, then there will be no public sector borrowing requirement in 2006. But it is still too early to say that all the problems in this regard will be solved.
• Another prerequisite is the existence of a healthy banking sector. After almost collapsing in 2001 the banking system has recovered significantly over the last four years. But it is still not completely healthy.

The confidence problem has been solved
• One of the key prerequisites for the success in inflation targeting is confidence in the Central Bank and the government. In 2001 confidence in both institutions hit rock bottom. But there has been considerable progress in this regard over the last four years. The facts that since 2002 inflation has always been less than the target and that it has fallen to single digits for the first time in 33 years has increased confidence in the Turkish Central Bank. As a result, in this regard the situation today is sufficient for the transition to inflation targeting.

• Another prerequisite for success in inflation targeting is the application of a floating exchange rate policy. A floating exchange rate policy was introduced in 2001 but it was not clear how successful its application would be. But nearly  five years after its introduction we can say that, as regards this prerequisite, the situation in Turkey is good.

• There needs to be a weak relationship between the exchange rate and inflation in order for inflation targeting to be successful. Before the introduction of the floating exchange rate policy, the relationship was very strong in Turkey. But research shows that this relationship has weakened since the introduction of the floating exchange rate.
• The last prerequisite for the success of inflation targeting is that inflation should be less than 10 percent during the transition period. We see that this condition has been fulfilled today.

Inflation targeting and macroeconomics
As the brief analysis above shows, we already have most of the prerequisites for success in inflation targeting. Of course, there are also some areas where we are still at a disadvantage. But in these areas the situation is continuing to improve. For this reason, we believe that Turkey has a good chance of success in inflation targeting.

Inflation targeting is attracting increasing interest around the world because people believe it has a positive impact on macroeconomic performance. This view has been confirmed by most of the findings of studies that have been conducted. In general, those countries which have introduced inflation targeting have undergone a subsequent improvement in macroeconomic performance. But macroeconomic performance improved in virtually every country from the second half of the 1990s onwards, which has led some to argue that inflation targeting did not bring any extra benefits. But the fact that none of the countries which introduced inflation targeting has experienced a deterioration in macroeconomic performance has meant that there has been little opposition to its application.

Inflation targeting in emerging markets
One of the most recent studies on the impact of inflation targeting on macroeconomic performance was conducted by the IMF. In a section of its report entitled ‘World Economic Outlook’, which was published by the IMF last September, examined the impact of inflation targeting on macroeconomic performance in emerging markets.

The results of this study show that inflation targeting has a positive impact on macroeconomic performance in emerging markets. The results of the survey, which covers the years 1990-2004, show that inflation falls by 4.8 points in countries which have introduced inflation targeting compared with countries which have not introduced it. The results of the study indicate that inflation volatility, that is to say fluctuations, also declined more rapidly in countries which had introduced inflation targeting. The same results could be seen in variations in the production deficit. But it has not been proved that inflation targeting has a significant impact on growth rate volatility.

We hope that the introduction of inflation targeting in Turkey will bring with it an improvement in macroeconomic performance. 

The application touchstones
Inflation targeting in Turkey is set according to the Consumer Price Index (TÜFE). The target for TÜFE inflation is 5 percent at year-end 2006, and 4 percent at year-end 2007 and 2008.

The inflation target is not a band but a specific figure. But, as it is difficult for inflation to come in precisely on target, as in most other countries, there is an uncertainty variable. The uncertainty variable for 2006 is plus or minus 2 percentage points.

There are also quarterly targets for 2006. These targets are 7.4 percent at end-March, 6.5 percent at end-June and 5.8 percent at end-September. These are also the targets included in the Standby Agreement with the IMF.

If inflation comes in 1 percent higher or lower for these quarters or for end-2006 then discussions will be held with IMF officials. If the realizations are 2 percent higher or lower, then the reasons will be analyzed and made public. In addition, recommendations will also be made to the government regarding what measures that need to be taken.

HOUSING CONSTRUCTION RETURNING TO THE OLD DAYS
The boom in housing construction which began in the second quarter of the year continued in the third. According to figures from the State Institute of Statistics (TÜİK), work began on the construction of 337,244 new housing units in the period January-September 2005. This represents an increase of 57.3 percent compared with the same period in 2004. In addition, the number of new housing units on which work began in the third quarter was more than the number which were completed in 2004. In 2004 as a whole, the total number of new housing units on which construction work began was 342,589.

For the construction sector, the liveliest time of the year is usually the final quarter. This general trend is unlikely to have changed in 2005. For this reason, we estimate that the number of new housing units on which work began in 2005 as a whole will be close to 500,000.

If our forecast is realized, the performance of the construction sector will approach the golden days of the mid-1990s. To date the year in which the highest number of building permits has been granted in Turkey is 1993. In 1993 the foundations were laid for 548,000 units. Work also began on more than 500,000 units in 1994 and 1995.

This boom in the construction sector has been partly fuelled by the increase in demand as the result of a rise in the granting of loans. The rise in demand for housing has not only produced an increase in new building but has also resulted in buildings under construction being completed as soon as possible and made ready for people to move in. In the period January-September a total of 146,863 apartments were completed and made ready for habitation. This represents an increase of 37.5 percent on the same period in 2004.

In the period 2002-2004 the total number of apartments which were completed ready for habitation stood at around 160,000. It looks as though this number will exceed 200,000 in 2005. The record for the number of apartments which were completed and made ready for habitation was set in 1997 at 277,000.