The Economy And Monetary Policy

During the 1990s insensitivity in the management of the economy in Turkey had reached such a point that neither financial policies nor monetary policies had any effect. In this period, governments’ only concern was to get reelected and, as a result of the budget deficits and increasing interest payments, it became impossible to apply a monetary policy to manage the economy. The sole aim of any financial policy was to secure the necessary borrowing and to save the day. In this period, the Central Bank was entrusted with keeping interest rates as low as possible and making it easy for the Treasury to borrow. As a result, monetary policy was not used to manage the economy.

The measures which had to be taken after the meltdown of 2001 have today begun to bear fruit and we are seeing the Central Bank’s trying to apply its monetary policy for its true purpose. Because in a system in which inflation targets are openly declared, the Central Bank is responsible for any deviations from the target for inflation. In order to ensure that there is no deviation from the target for inflation, the Central Bank needs to use its monetary policy in an effective manner. We can see that, as in developed countries, the Central Bank is using short-term interest rates as an instrument of monetary policy in order to achieve this target.

Shift in monetary policy

Before 2001 the governor of the Central Bank had the authority to set short-term interest rates. As a result of a legislative changes in 2001 this authority was transferred to the Monetary Policy Council (MPC) in the Central Bank. The increasing importance of monetary policy, since the beginning of the year, this council has met on the eighth of every month. After every meeting, the Central Bank announces the short-term interest rates that will be applied on the interbank money markets. Later the reasons for this decision are published in a report entitled ‘Inflation and Prospects’.

Until last month this decision was always to reduce interest rates. The Central Bank reduced the overnight borrowing rate from 18 percent at the beginning of 2005 to 14.25 percent in June, while cutting the lending rate from 22 percent to 18.25 percent. But at the most recent meeting, which was held last month, there was no decision to reduce interest rates. After the meeting the Central Bank announced that it had not changed the interest rate. This indicates that there has been an important chance in its monetary policy.

The reasons for the decision

The ‘Inflation and Prospects’ report that was published after the meeting gave the explanation for the decision as concerns about meeting the target for inflation in 2006. According to the Central Bank, there is no problem in meeting the inflation target of 8 percent for this year. But the Central Bank believes that a boom in domestic demand may prevent Turkey from meeting the inflation target of 5 percent in 2006. Research has shown that decisions related to monetary policy need from six to nine months to have an impact and so, in order to avert the danger, something needs to be done now.

There was speculation on the markets that one of the reasons for the decision by the Central Bank temporarily to halt the reductions in interest rates was the suspension of the first review of the new Standby Agreement. But Central Bank Governor Sürreya Serdengeçti resolutely refutes this.

Did the postponement have an impact?

But when we look carefully we believe that the postponement of the review of the Standby Agreement did indeed have an impact on this decision. The reason for the postponement of the first review was the delay in the structural reforms that had been set as performance criteria. This appears to be indicate what had once looked like reform fatigue in the government has now become reform stagnation. Everybody knows how critical the Central Bank believed structural reforms were for the transition to inflation targeting. The Central Bank has stressed this in every report. We think that this has also had an impact in the suspension of interest rate cuts but that the Central Bank has not stated this explicitly in order not to create tension in the management of the economy.

One of the reasons we think like this is that we do not see the boom in the economy mentioned by the Central Bank. On the contrary, in the second quarter of the year the growth rate of the economy was close to one normally associated with a recession. In order for the economy to meet the growth target of 5 percent in 2005 there needs to be a real boom in the economy in the second half of the year.

Testing times for the Central Bank

But we cannot be adamant about this. The Central Bank employs a lot of researchers and in recent years it has commissioned a lot of studies which identify the dynamics of the economy and it is able to follow the economy much better than we can. When we also bear in mind that is has access to a lot first hand data, then we have to take what the Central Bank says seriously.

But, by announcing that the inflation target for 2006 is in danger because of expectations of a boom at a time when there concerns about a possible recession, the Central Bank has put its neck on the line. The Central Bank takes every opportunity to declare that it focuses not on the current state of the economy but on prospects for the future. As a result, if its prediction comes true than its credibility will increase still further. Whatever the Central Bank says in the future will be taken even more seriously. Serdengeçti can become a legend like FED Chairman Alan Greenspan, whose every statement is analyzed for meaning. But, if the Central Bank’s prediction does not come true, it will lose some of the credibility it has gained from inflation always coming in under the target over the last three years.

If the Central Bank fails this test then the results could be bad for the economy. Because if the economy is heading towards a recession anyway, the Central Bank’s tight monetary policy will deepen this recession still further. This will have a negative impact on employment which is only just beginning to increase. Then the problems of hunger and unemployment will feed on each other.

THE BUDGET DEFICIT HAS SHRUNK BY THREE QUARTERS

In the last few years we have clearly seen the benefits of the measures that were taken after the 2001 crisis. One of these things that we have seen is the data related to the consolidated budget. The budget deficit, which was one of the reasons for the Turkey sliding into bankruptcy in 2001, is continually contracting. Interest payments are also declining as a result of the decline in interest rates.

Last year, for the first in time in many years, the budget deficit contracted even in nominal terms. The realized figures for the first six months of the year indicate that something similar is going to happen this year.

According to figures from the Ministry of Finance, over the first six months of the year the budget posted a deficit of YTL 3.9 billion. Whereas the deficit over the same period last year was YTL 14.6 billion. This means that the budget deficit contracted by 73.5 percent over the first half this year compared with last year. To put it another way, the deficit shrank by around three quarters.

When we look for the reasons for this development we see interest payments. In the first six months of the year the Treasury paid a total of YTL 23.4 billion in interest payments. In the same period last year it paid YTL 29.6 billion. This represents a decrease of 21 percent.

This decrease in the interest payments ensured that the rise in budgetary expenditure was only 1.5 percent. The fact that there was no slowdown in non-interest expenditure, which mainly comprises wage and salary payments, prevented a greater improvement in the budget.

At this point, one should add that there was a significant real increase in budgetary revenue. This is another of the reasons for the improvement in the budget.

The rate of the budget deficit to national income, which until 2003 had always been in double figures, fell last year to 7.3 percent. It looks as though this year the rate of the budget deficit to national income could fall to around 5 percent. If there is no deviation in monetary policy, in a few years we could reach the Maastricht criteria of 3 percent.