'Should the BRSA step in, the contradiction would be eased. To completely eradicate the contradiction, political authority must also get involved.'

'The routine-breaking' monetary policy have brought about many article topics. In my last year in the Central Bank of Turkey (CBT) I started to become quite bored. There was no motion. Inflation was no more a problem, targets were being met. Moreover, Turkey grew at a rate above the long-term average. The only potential source of motion was the potential steps to be taken to reduce current account deficit.

Different than today, current account deficit was being financed via long-term funds. Still, motion was necessary. We were thinking what could be done. But 'those that were supposed to step in to make a wall pass' were lying low implying that the CBT has to skin its own skunk as if the problem in question was not a problem for all of us. So, at those times of inertia, eight months before the end of my term in the office, I decided to get back to the salt mines and initiated the procedures for teaching at the university. Fortunately, the current CBT administration has relieved this 'former columnist-former CBT official-once again columnist' of a similar inertia. I am really thankful.

The CBT has reasons to cut the interest rate

But once again it seems that the CBT does not have anyone to make a wall pass at. Under these circumstances, the policy, even it breaks the routine, faces important challenges. The relatively less important challenge is the risk that while the CBT reduces the policy rate, inflation tends upwards pushing the inflation rate away from the target. Should this happen, I already know what I will say: "Headline inflation is not problematic; it is in line with the medium-term targets." The target was missed in three of the last five years whereas the headline inflation rate always stood way below the inflation. Also in the last two years where the target was met, headline inflation was again way below the inflation rate. In short, the headline inflation does not imply anything of fundamental importance; the potential declaration by the CBT that inflation is not problematic therefore will not serve the purpose.

The CBT has understandable reasons to reduce interest rates in spite of this potential risk. It wants to discourage short term foreign capital inflows which become increasingly dangerous for financial stability. But reducing interest rates alone will not solve the problem. It is also necessary to solve the rapid credit expansion reinforced by short term foreign capital inflows. To solve this problem, the CBT took the routine-breaking path and increased the required reserve ratio.

Turkey's context

Reducing the interest rate and increasing the required reserve ratio as policy measures contradict with Turkey's specific context for the Bank needs to meet the short term capital needs of commercial banks so as to maintain the interest rate at the level it set. Why is "Turkey's context" emphasized? Under normal conditions, it is not expected that banks extend long term credits with the liquidity the central banks sell with a weekly maturity. If so, you on the one hand increase the required reserve ratio to limit the amount of funds that can be extended as credit, and on the other hand meet the short-term fund needs of banks. This overhauls the contradiction.

But the problem is that in Turkey maturity of deposits is a couple of months in average. Therefore, funds composed of short term deposits and weekly funds purchased from the CBT become highly interchangeable. This makes the routine-breaking policy contradictory. But should the BRSA (Bank Regulation and Supervision Agency) step in, the contradiction would be eased. To completely eradicate the contradiction, political authority must also get involved. There also is a funny part of the story: total deposit cost. I will talk on this in the next commentary.

This commentary was published in Radikal daily on 01.02.2011