The infantry rifle the CBT fired hoping for the impossible might backfire, harming its own reputation. The number of players on the pitch must be increased as soon as possible.

Recently I have written a number of commentaries on monetary policy. The first reason was that the monetary policy in effect was an unusual one. Second was that there populated many reports that have the potential to harm the reputation of the monetary policy authority. Third reason was that financial investors frequently expressed that they were confused by the new policy framework. Therefore, it was necessary to address the new monetary policy in detail.

It certainly is not a drawback that the new monetary policy is out of the routine. The global crisis has proved one more time how important the financial stability is. With this lens, there is nothing weird in seeking for a new monetary policy practice.

The weird part is different. First one stems from the fact that in the context of the inflation targeting regime which is declared by the Central Bank of Turkey (or the CBT) to be applicable, the CBT has to sell banks the liquidity they demand so that the targeting regime can fulfill its purpose. The bank assumes that increasing the reserve requirements alone can slowdown the credit expansion even if no other relevant institution steps in. I have focused on this issue several times and I will skip it now. Today I am rather interested in another important weirdness.

As the CBT's statements reveal, to fulfill the main objectives, which are the price stability and financial stability, the bank's new policy has set three intermediate targets: maintaining the inflation in an interval close to the target, reducing short term capital inflows and limiting the rate of credit expansion. Today I want to focus on an issue that went unnoticed in my commentaries, that is, the target of reducing short term capital inflows.

Unfortunately, the points I will highlight are not favorable ones. The underlying reasons for the negative outlook are as follows. To begin with, it is not meaningful to set a variable which the CBT does not have a control over as an intermediate target. In other words, the tools at hand are not powerful enough to fulfill this target. There is no point in shooting a target with an infantry rifle as it is as big as it can be demolished with a guided missile. Second, the rifle might backfire and shoot you.

The CBT can do two things with the rifle to reduce capital inflows. First to reduce the CBT's borrowing rate in order to prevent the trading in which FX denominated in currencies of low-interest countries are brought to Turkey, invested to generate high interest revenues, converted in the short term benefiting from low exchange rates and taken back to the home country. The CBT has already reduced the borrowing rate, which was an action to the point. Second is to lower the interest on weekly lending, which is the main interest tool of the CBT and which can be considered to be the fundamental short term benchmark interest rate. 

The risk of backfiring

This is where the risk of backfiring of the rifle, which is already insufficient to overcome the problem, rises. This policy might contradict with the other two intermediate targets. It might be inconsistent with the target to maintain the inflation close to the targeted level. Second, the Bank on the one hand aims to reduce the pace of credit expansion and on the other hand reduce the interest rate, which might not only increase the credit demand but also reduce the cost of borrowing from the CBT to compensate for the reserves it withdrew. What is more, the key actors who can actually prevent the short term fund inflows are in the audience. You have to invite them to the pitch, but you do not.

So, what is the guided missile? There are two non-contradictory methods to struggle with short term: capital controls and tightening the fiscal policy. Since the economy administration categorically objects to the capital controls, it is a must to tighten the fiscal policy. Otherwise, the infantry rifle the CBT fired hoping for the impossible might backfire, harming its own reputation. The number of talented players (furnished with guided missiles) on the pitch must be increased as soon as possible.

This commentary was published in Radikal daily on 09.06.2011