What if the BRSA does not step in? If so, the CBT will have to settle with one intermediate target, that is the inflation target.

My previous commentary on the possible monetary policy after the elections turned out to be so long that I could not dig into the main issue, the monetary policy. I said: "...Fiscal policy would have been tightened. Measures to slowdown the credit expansion would have been implemented in collaboration with the Bank Regulation and Supervision Agency (BRSA). With these two critical steps, the monetary policy that has been implemented since the second half of 2010 would have been replaced with a more usual one. Great minds think alike; I believe that these steps will be taken." 

Credit expansion can be limited
I have to specify the concept of 'usual monetary policy'. Since the second half of 2010, the monetary policy aims to reach three intermediate targets in tandem with two ultimate objectives: to ensure that inflation rate converges to the target, to slowdown to a certain extent the rapid increase in the credit supply and to initiate measures to reduce short term capital inflows. This third intermediate target has certain drawbacks in this current milieu. The usual policy, on the other hand, focuses on the first two intermediate targets and excludes the third one.

Since the tax measures to discourage foreign exchange (FX) inflows are categorically rejected, the most important policy tool against short term capital inflows is tightening the fiscal policy. By doing so, you aim to reduce the foreign borrowing requirement via increasing public savings. Second, you can slow down the domestic demand. If the BRSA steps in (say via a regulation that sets an upper limit for the ratio of weekly borrowing from the CBT to balance sheet value or another measure that serves to the same purpose). This eases the pace of domestic demand reducing the foreign borrowing requirement.

If these measures are introduced, the CBT will be able to breathe again. There will be no need to use the infantry rifle that can fire back against targets that must be dealt with guided missiles just because it lacks one. It will be able to turn back to the usual monetary policy framework. In short, it will focus on the inflation and credit expansion as main intermediate targets.

This does not imply that the CBT has to increase the interest rates from now on. It implies that the interest rate tool will be used only in relation with the inflation targets. But any effort to prevent short term capital inflows as a third target might contradict with the inflation targets, leaving interest rate out as a policy tool. There is no contradiction if the inflation is on track. You can reduce the interest rate which will be in harmony with the other two targets. But if the inflation is increasing comes the contradiction: you had to increase the interest rate if the inflation was the sole target. However, given the current global milieu, an increase in the interest rate raises the possibility of a hike in short term capital inflows.

What must the CBT do, then? What I refer to with the usual monetary policy concept is to overcome this contraction. First, interest rate tool must be used solely for inflation targeting. Second, since the BRSA will also step in, the CBT can use the reserve requirement tool against credit expansion as it has been doing since the second half of 2010. That is, the CBT must proceed with two intermediate targets instead of three.

What if the BRSA does not step in? If so, the CBT will have to settle with one intermediate target, that is the inflation target. Because, as already discussed before, within a framework that does not involve the BRSA, the reserve requirement tool of the CBT works only if the requirements are raised substantially. This has three drawbacks: first, it puts an unnecessary cost burden on banks. Second, it encourages increasing weekly borrowing from the CBT which affects banks' balance sheets negatively. Third, the CBT seeks to increase the risk perception of banks so that they cannot offset the rise in reserve requirements by increasing borrowing from the CBT. In this context, the CBT allows the interest rate in the short term fund market to diverge from the policy rate. This in the end turns the interest rate into a useless tool.

This commentary was published in Radikal daily on 14.06.2011