Evaluate the new multi-purpose-multi-tool monetary policy framework of the CBT: is it successful in shaping prospective expectations?

I will get at the Central Bank of Turkey (CBT), but I first have to visit Sweden and then the US. One of the biggest contributions of Thomas Sargent, one of the winners of the 2011 Nobel Prize in Economics, to the literature of economics was about the expectations economic actors set about future value of important economic indicators when making prospective decisions. Expectation is a key subject in economics.

For instance, if you expect that the value of dollar against the Lira will increase significantly, you will go and purchase dollars today. So does other individuals if the dominant expectation across markets as well is in this line. You cannot guess a future increase in dollar exchange rate with divine inspiration. There might be some indicators that the central bank will cut interest rate substantial. In addition, you might be foreseeing certain developments that have the potential to reduce the risk appetite of domestic and foreign financial investors.

The future of the exchange rate

Then, expectations about the future value of the exchange rate per se depend on the future shape of the economic policy. This is a critical point Sargent and his colleagues emphasized in several studies. Before Sargent and a group of economist which also had won Nobel prizes have identified this critical phenomenon, economists used to formulate and study macroeconomic models under the assumption that prospective expectations are determined by past or present economic policies.

To clarify the importance of this identification, let me address the ‘supposed’ relationship between inflation and unemployment rate (or growth rate). According to this, inflation rate can be lowered only in exchange for a rise in unemployment rate (or a drop in growth rate). This is why you can occasionally come up with comments like “So what! Do you want the central bank to reduce growth rate?” in economy programs in which central bank policies are discussed.

In technical terms, the relationship goes like this: The difference between inflation and expected inflation (inflation gap) is positively related with the difference between growth rate and potential growth rate (growth gap). Let us assume that there is a one-to-one relationship between the mentioned two concepts. Let’s say that in a country, year-end inflation is estimated to be 30percent and the government targets to lower the inflation to 10 percent by the end of next year. Also assume that the potential growth rate of the country is 5 percent. The question is: what will be the growth rate in the following year if the government manages to lower inflation rate to 10 percent?

Here comes the answer: if it is thought that inflation rate in the next year will not be different than that in the current year (30 percent), inflation gap  on the basis of the 10 percent inflation target for the next year will be -20 (10 minus 30). If so, growth gap must also be -20. That is, next year’s growth will be -15 (5 minus 20)! If there had been confidence in the anti-inflation program of the government, on the other hand, inflation expectation for the next year would have been equal the targeted 10 percent and there would have not been any inflation gap or growth gap. Thus, growth rate for the next year could have been 5 percent! You would not have been faced with a dilemma where you need to compromise growth in exchange for lowering exchange rate or inflation target in exchange for maintaining the growth rate. Of course in real life the economy does not run in such a mechanic manner. What matters is that how expectations are determined and to what degree economic policy makers and implementers succeed in shaping these expectations are of vital importance. So, evaluate the new multi-purpose-multi-tool monetary policy framework of the CBT with this perspective: is it successful in shaping prospective expectations? I will give the answer in coming commentaries.

This commentary was published in Radikal daily on 25.10.2011