What matters is the impression created by the CBT that the variables that matters changes continuously and the uncertainties raised in such an environment.

It is useful to put emphasis on the objective-tool issue once again. For some time now, inflation targeting is cursed and a new monetary policy regime to replace it is being sought. However, the necessary institutional structure is not ready yet. So, today let me try to express myself in the context of the inflation targeting regime at the risk of ending up with a “technical” assessment. In the inflation targeting regime framework, the main objective is to maintain price stability. Any other objective is secondary and comes to the agenda provided that it does not contradict with the main objective. There is a single main policy tool in this regime: short-term interest rate. Of course this can be backed with other tools. A central bank implementing inflation targeting regime communicates solely through the interest rate. That is, it declares its estimations about the future value of inflation and discusses to what degree the estimations are in line with targets. If the two are not in harmony, it decides to change the interest rate and expresses the rationale of this change with reference to the estimation-target harmony. Evidently, the future path of inflation rate depends on a number of factors among which are economic growth rate, exchange rate, price of imported energy inputs etc.

A three-variable model

Everything is okay up to this point. However, some parts of the story are generally missed out: all inflation targeting models in the economics literature starts with an “objective function”. Excluding hard inflation targeting regime which is not used in practice except special cases, the objective function constitutes two main variables. First is the difference between the inflation rate and inflation rate target. Second is the difference between the level of production and potential level of production. If required by specific economic circumstances, a third can be added to the picture: for example the difference between real exchange rate and “equilibrium” level of real exchange rate. This third variable is not used in practice; but theoretically such a model is possible. Cautious readers will remember that some time ago I addressed several times discussing the possibility of a three-variable model for Turkey. When you solve this three-variable inflation targeting model, you obtain an interest rate reaction equation which gives you a hint about the value interest rate should take. Evidently, central banks benefit also from other models, lead indicators, negotiations with the financial sector, information obtained in international meetings from other central bank officials, and potential developments about domestic fiscal policy when making decisions. However, the chief point for the purposes of this commentary is that a central bank with a single objective does not rely solely upon the difference between inflation rate and inflation target when deciding on the interest rate.

Weights might change

The second important point is that the two “difference” variables (or three with the additional one) I talked about above are involved in the “objective function” with certain weights. For instance, the central bank might set the weight of the difference between inflation rate and inflation target at 70 percent and that of the difference between production level and potential production level at 30 percent. These weights remain constant in the short term; they are not changed before each monetary policy council meetings for instance. It might be necessary to change the weights under certain conditions. For instance, a severe crisis might increase the weight of production against other variable(s). But after the changes, the weights should remain constant for a considerably long period. This was where the biggest weakness and danger about the latest decisions of the Central Bank of Turkey (CBT) lies. The weights of the indicators have been changing with a dazzling pace. Two months ago the weight of inflation was too low and that of growth was too high. After a couple of months, the picture was reversed completely. Then, the dominance was shifted to exchange rate. This rapid change gives way to a large uncertainty. You might say that the CBT does not have a single target; it uses multiple policy tools and (maybe) does not implement an inflation targeting regime. But these are not among the concerns of this commentary. What matters is the impression created by the CBT that the variables that matters for the CBT changes continuously and the uncertainties raised in such an environment.

This commentary was published in Radikal daily on 01.11.2011