The Central Bank's actions should no longer be thought of in the usual inflation targeting framework.

Since mid-2008, early 2009, the previously observed inertia in headline inflation has somewhat been broken. Also, yearly headline inflation, measured according to the core inflation index which has been increasing since October 2010, has been following a downward trend since 2004.

The consumer, as well as core inflation, is displaying significant fluctuations due to these crude trends. These crude trends, when considering the basic function of price stability, has until now somewhat relaxed the Central Bank (CBT) and allowed it to pursue financial stability. So how will monetary policy take shape from now on?

Despite fast growth, level of production remains far below the potential. The fact that exports have not reached pre-crisis levels played a significant part in this phenomenon. Developments until the first quarter of 2011 therefore display growth driven by domestic demand. This tells us that downward pressures on inflation caused by production below potential levels during normal times will be insufficient. We must evaluate domestic demand to determine whether these pressures will manifest. From the perspective of price stability, these developments will not upset the CBT: There are indications that growth in domestic demand will slow in the second quarter.

The development which could worry the CBT would be the further devaluation of the Lira. I say "further devaluation" because current devaluation, considering price stability, is not a cause for concern. It is even possible to say that the CBT is displeased with this in the framework of the new policy composition.

What becomes evident considering the framework of the fundamental goal of monetary stability is this: The CBT could tell us a few more months that time is needed before the effects of their decisions  as well as decisions the Banking Regulation and Supervision Agency's (BRSA) took after the elections can be seen.

Under these circumstances, we should expect an interest increase from the CBT. If needed, the BRSA will be asked to take additional precautions and/or increase the required reserve ratio. It looks like the CBT's change of its interest policy depends on the realization of one of these two possibilities. Firstly, if the US CBT was to tighten its monetary policy, the CBT could follow with some time lag. Secondly, if there is an acute downturn in the global appetite for risk and the exchange rate jolts up, the CBT will increase interests. But what if consumption inflation goes up from its current level before either of these two conditions takes place?

As long as there is no striking increase, the CBT will not increase the policy interest rate and we will hear the following. One: Inflation base trends are in line with medium-term goals (see above "break" argument.) Two: The increasing trend in core inflation is not permanent (see above mentioned fluctuations around the downward trend in the core inflation index) Three:  Inflation at the end of the year will be above target, but in light of available information, there is no reason why medium-term goals should not be accomplished (relying on the first two reasons) in the medium term.  Four: Monetary policy is already leaning towards tightening (due to the high required reserve ratio and the increased capital adequacy ratio.) Five: We will tighten this stance if additional information requires us to do so (the BRSA taking precautions and/or the increase of the legally required reserve ratio.) Six: The stance of fiscal policy is important for monetary policy. Seven: The new medium-term program confirms that this stance is disciplined.

The CBT's actions should no longer be thought of in the usual inflation targeting framework. The CBT is increasingly moving away from the usual inflation targeting regime. This is why those who expect an increase in interest rates from the CBT have lately been wrong. But is the Central Bank still implementing targeted inflation in some usual corner? Is it doing the right thing? How convincing are the above things we "will hear" from the CBT? All this is worth discussion soon.

This commentary was published in Radikal daily on 07.07.2011