The CBT has not yet introduced required reserves for weekly borrowing from the CBT.

The Central Bank of Turkey (CBT) employs inflation targeting regime to enable price stability. It has two targets: to ensure that the inflation rate stands close to the target and that production level converges to the potential. On the basis of the characteristics of the economy (the factors that affect the inflation rate and the level of production) and the targets stated above give a policy rate response equation is derived. Interest rate responds to the difference between actual and potential production level, the real value of domestic currency, foreign real interest rate and shocks affecting supply and demand.

The decrease in the budget deficit, level of production standing below the potential, extremely how interest rate abroad and real appreciation of the lira reduces the CBT's concerns about inflation. You should also note the positive psychological impact of fulfilling the 2010 target and inflation estimate of the CBT being in line with the inflation target. 

Financial stability

In such a milieu, it is evident that the CBT does not need to increase the policy rate. But does it have to decrease it? If you approach the question solely in relation with price stability target, the CBT might reduce the rate for three reasons: If the headline inflation indicators are way below the target, if it is aimed to maintain the real value of lira close to the 'equilibrium value' as a third target supplementing the two mentioned before, and if the former two takes place simultaneously.

Now let us deal with the financial stability target. Different than the past, high current account deficit is financed predominantly by short term capital inflows. This is triggered by the extremely low interest rates and substantial monetary expansion in developed countries. Credit expansion is quite rapid across domestic banks. The CBT is concerned that the said developments might hinder financial stability.

In that case, even if increasing the policy rate limits credit expansion, it will in any case accelerate short term capital inflows. Thus, increasing the interest rate will trigger either one of the factors disturbing financial stability while remedying the other one. What is more, the CBT does not have to increase the interest rate when the price stability is concerned.

There is need for a second policy tool. The CBT seeks to reduce the volume of funds to be extended in form of credits by increasing the required reserve ratio.  This is an efficient tool to overhaul the second factor threatening the financial stability. But what must the Bank do to overcome the first challenge? First, it punishes the banks for their short term borrowing by increasing the required reserves for this sort of borrowing activities. Second, it applies to the old policy tool and reduces interest rates. 

Liquidity shortage

The new policy composition sounds quite good when considered separately for each of the two targets of the Bank. But there is a problem. So as for the policy rate set by the CBT to be functional, the market interest rate appearing as a result of the interbank transactions have to be close to the rate set by the CBT. There exists shortage of liquidity in the market. The CBT has to remedy this shortage - sell liquidity to banks - in order to ensure that the market interest rate does not diverge from the CBT's policy rate. But instead the CBT withdraws liquidity from the market by increasing the required reserve ratio.

This problem can be eased with two methods:  First is allowing the market rate to diverge from the CBT's policy rate to a certain extent.  The CBT already announced that this action will be taken. In addition, in the previous Monetary Policy Committee meeting the Bank widened the interest rate corridor upwards increasing the overnight borrowing interest rate and thus expanded the room to maneuver. The second method is introducing required reserve ratio on weekly borrowing from the CBT by banks. This path is yet not taken.

This commentary was published in Radikal daily on 27.01.2011