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Lessons from 2011
Central banks can implement an inflation targeting regime that also safeguards financial stability using old policy tools and the old policy framework.
2011 was a very interesting year. The headline was the new monetary policy of the Central Bank of Turkey (CBT). This attempt was debated widely and assessed vastly by many columnists, including myself. In these last days of 2011, I want to assess the new monetary policy of the CBT once again, but with a different perspective this time.
We all know that before the global crisis, many central banks including the CBT predominantly had paid attention to price stability. This does not mean that financial stability had not been of importance. For instance, “introducing measures to maintain financial stability” are among the “fundamental duties” of the CBT as per Article 4 of the CBT Law amended on 25 April, 2001.
Along with the global crisis, importance attached to financial stability has grown. Therefore, economists specialized on monetary theory and monetary policy started to investigate what type of monetary policy a central bank attaching equal importance to price and financial stability should implemented. Some of these studies tended to revise the inflation targeting theory.
In the past, inflation regime focused on keeping the level of production close to the potential level of production as well as minimizing inflationary fluctuations beyond the target. In addition to these, another variable about financial stability is involved in the objective function of central banks. We can call this the leverage ratio and assume that it decreases as the level of production increases. That is, when things are on track, the presumption that things will stay on track spreads and relevant actors tend to take riskier steps. This is a phenomenon the global crisis had validated.
During the last two weeks I made two presentations on this subject, one in the Middle East Technical University and the other in Gazi University. During these, I shared the results of a simple model I had designed. According to this simple model, central banks try to keep this leverage ratio at a reasonable level as well as minimize the inflationary fluctuations and the difference between potential and actual level of production. If the model is solved, an interest rate equation is obtained. The difference in comparison with the regular model is that the interest rate response becomes smaller if inflation rate goes off track, and larger if the production diverges of the potential. In addition, central banks respond to the leverage ratio (or a similar indicator) when it goes off track. The response to the divergence of real exchange rate of the balance remains the same with that in the regular model.
I am giving these details not because I want to say, “What a perfect model I designed.” In fact, this really is a simplistic model. Still, it validates that a central bank can implement an inflation targeting regime that also safeguards financial stability using old policy tools (that is, policy interest rate) and the old policy framework. Especially if the mentioned framework had previously been strengthened by furnishing the central bank with the authority to regulate banks’ capital adequacy ratio and similar indicators about macroeconomic stability, it does not even need to bother to change the framework. It does not need to attempt plans that are bound to fail, such as intervening in reserve requirements. I think this is the first lesson to learn from 2011. Certain authorities of the Banking Regulation and Supervision Agency must be transferred to the CBT. This was not what I argued one year ago; however, the year 2011 proved that it is necessary.
Let me touch upon the second lesson, as well. 2011 validated once again that, in a country like Turkey, which historically has a low savings rate (in fact the rate has decreased further in the last couple of years), or in other words, which can enhance growth only with the help of foreign funds, it is extremely risky for the central bank to intervene in the exchange rate, particularly if an external chaos is on the horizon. The CBT, however, did the opposite. In fact, until August, it bragged about the extended depreciation of the Lira. When things went out of control in Europe in August, exchange rate hiked, panicking the monetary authority. This time, the CBT had to sell massive amounts of foreign exchange to prevent any further deterioration. A clear U turn was taken before the first anniversary of the new monetary policy. This was a bad choice. And there is no need to embark on such adventures.
This commentary was published in Radikal daily on 27.12.2011