In order to ensure that the macro-prudential tool serves its purpose, the CBT is allowing the policy rate lose its influence as a policy tool.

On Saturday, I stated that the Central Bank of Turkey (CBT) has used the required reserve ratio as a macroprudential policy tool with the aim to lower the risk of financial instability stemming from rapid credit growth. This policy attempt, however, encountered a dilemma: If the banks wanted to maintain the current pace of increase in credit supply, they could offset the funds (deposits) the CBT withdrew via increasing reserve requirements by borrowing from the CBT on a weekly basis since the maturity of the withdrawn funds were remarkably low. In order for the weekly interest rate, the other policy tool of the CBT, to influence the market interest rate, the CBT had to lend banks short-term liquidity as much as they demanded. That is, it had to withdraw liquidity from one channel and inject it back from another.

There are two ways to overcome this dilemma. First option is to stick to the inflation targeting regime and strengthen it with a “correct” macro-prudential policy tool that will not hinder the operation of policy rate. Second is to focus on financial stability and set aside price stability, that is, to abandon or suspend the objective of inflation targeting. It appears that the CBRT has chosen the second path. First in 15 October 2010, it reduced the borrowing interest rate, widening the interest rate corridor down. On 12 November and 17 December 2010, the lower limit was decreased considerably while the upper limit was increased slightly. The CBRT also cut the policy rate (repurchase rate) simultaneously in both occasions. The mentioned policy rate and interest rate corridor were maintained and market interest rate was allowed to fluctuate significantly until 4 August 2011. In other words, over the mentioned period, the CBRT allowed market rate to deviate significantly from the policy rate on a daily basis.

Why did the CBRT allow the market rate fluctuate within a large interval? The aim was to overcome the abovementioned dilemma by raising uncertainty about the cost for banks of borrowing from the CBT and thus to prevent banks from maintaining the pace of increase in credit supply. This objective was verified in several remarks and presentations by CBT officials. Below paragraph is cited from an article by CBT Governor Erdem Başçı and Hakan Kara (İktisat, İşletme ve Finans, May 2011):

“... In order to enhance the effectiveness of reserve requirement ratio as a policy tool, the CBRT has allowed the interest rate volatility in the overnight market to fluctuate in a controlled manner, therefore letting the interest rate corridor become a more active policy tool (page 13)… Under the assumption that under normal conditions the entire amount of the liquidity withdrawn from the market via reserve requirement policies are financed by the central bank resources, the increase in required reserve ratios is not expected to have a significant effect on credit behavior… In practice, however, outcomes might be different. If banks fill the liquidity gap entirely by borrowing from the CBRT, they will shoulder the arising risk of interest… If the uncertainty about the future course of the policy rate is high, the interest rate risk banks will face by increasing short term funding will become even more marked. In fact, with the policy mix the CBT has been implementing explicitly since November 2010, it was aimed also to lower the ability to foresee the level of short-term interest rates and strengthen the interest rate risk channel through reserve requirement policies (page 15).”

The fluctuation in interest rate is continuing. The policy rate is a strong tool as long as it can affect the market interest rate. The way to affect the market rate, however, is to ensure that the short term market interest rate and the policy rate stand close to each other. However, the CBT has been allowing the former deviate continuously from the latter, in different directions and magnitudes. In a nutshell, in order to ensure that the macro-prudential tool serves its purpose, the CBT is allowing the policy rate lose its influence as a policy tool. How can the two tools work harmoniously? I will try to answer this question on Thursday.

This commentary was published in Radikal daily on 31.01.2012