The upwards trend in inflation will be temporary.

Inflation figures for November were announced. Annual increase in consumer prices reached 9.5 percent. Year end inflation for 2011 is expected to be around 10 percent. It appears that two elements were determinant of the rise in inflation: first, price of non-processed food products increased rapidly. Second, impact of the tax arrangements persisted in November, as well. None of these elements, however, have any significance for inflation dynamics unless inflation disrupts expectations and affect future contracts and thus push up the pace of increase in costs up. Still, let me check core indicators before reaching such an optimistic conclusion.

Unfortunately, there is an ongoing development that might disrupt inflation expectations: fundamental inflation indicators have been increasing continuously since the late 2010. Most quoted among these indicators are the H and I indices. According to H indicator, inflation has increased constantly from 3 percent in October 2010 to 8.5 percent in November 2011. Inflation on the basis of I indicator similarly increased continuously from 2.5 to 8.2 percent.

I indicator excludes food prices as well as alcoholic beverages and tobacco products the prices of which were affected by tax arrangements I talked about as the main driving factor for high inflation in November. Therefore, it is not possible to reach an optimistic decision about future inflation dynamics I referred to by the end of the first paragraph.

The details up to now concern the time spectrum until present. Concerning inflation expectations, however, possible future developments are more important. If the upwards trend in inflation is expected to continue, pace of increase in production costs and thus inflation will inevitably rise. Are we faced with such risk?

The future course of inflation rate will be determined by two factors: growth rate and exchange rate. As the medium term program suggests, growth rate in 2012 will be 4 percent. On the other hand, OECD expects 3 percent. There is a considerable risk that the actual 2012 growth remains below the estimations. In fact, Turkish economy might even face a contraction depending on the developments in Europe. Hence, it is evident that this remarkable drop in the growth rate compared to 2011 will also push inflation rate downwards.

On the other hand, changes in exchange rate will most likely not affect inflation positively. Eurozone banks have to increase their capital by € 106 billion by the end of June 2012 (in order to maintain their current size) unless a decision in another direction is taken at the end of the summit on December 9^th. It is expected that majority of banks will prefer to cut their size instead of finding additional capital. In that case, emerging market economies that receive substantial amounts of loans from European banks might be affected negatively. For Turkey, which has high current account deficit and thus high finance requirement, this means a depreciation pressure on the Lira. Therefore, a possible increase in the exchange rate would increase inflation.

Then, what might be the net impact of these two developments in opposite directions? I do not believe that the upwards trend in inflation will be permanent under these circumstances. Certain developments that might put pressure on inflation by increasing exchange rate (except pressuring Central Bank policies) will at the same time put a downwards pressure on growth and thus on inflation. The net impact on inflation most likely won’t cause inflation to reach higher than that expected for the end of 2011 or the beginning of 2012.

This commentary was published in Radikal daily on 06.12.2011