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    Lessons from the exchange rate policy

    Fatih Özatay, PhD26 July 2012 - Okunma Sayısı: 1024


    When implementing such policy, anti-inflationary efforts mustn’t be decelerated – or steps to create an impression as such must be avoided.

    For a couple of weeks I have been discussing if it is possible to implement a monetary policy that focuses on price stability as well as the value of the lira against FX. Now it is time to address lessons I learned from the Central Bank’s (CBT) policy between the late 2010 and August 2011 to lower the value of lira against FX.

    First, let me remind the main principle: In order to be fruitful, this policy mustn’t put a significant upper pressure on inflation. Expected outcome of this policy is mainly to prevent the financial vulnerabilities caused by the appreciation of lira above a certain level. The side-product of such policy – which, for some analysts, is the main objective – is to prevent a possible fall in Turkey’s international competitiveness.

    Old habits die hard

    Here is the first lesson: if factors that you cannot control are pushing up exchange rate, this policy will be unfruitful. It may be correct that circumstances in Europe weren’t as bad as today when the CBT first initiated the policy. But we mustn’t forget that we were discussing the state in Greece and later in Portugal and Ireland back then. Following these, Spain and Italy came on the agenda. What is more, during 2010 a number of unfruitful steps were taken. Then also were European leaders beating air. In a nutshell, things were already bad, if not as much as they are today. In the end, beginning in August 2011, risk appetite decreased considerably and lira depreciated to a large extent out of the CBT’s control. This played a significant role in the hike in inflation, too.

    Second, when implementing such policy, anti-inflationary efforts mustn’t be decelerated – or steps to create an impression as such must be avoided. I think analysts will generally agree that such impression was, righteously or not, created when the CBT first initiated the exchange rate policy. There was the belief that from the end of 2001 crisis to the global crisis, the habit of investing in FX faded largely. But it was later seen that the old habit rose in case of a sudden hikes in exchange rate, especially if the hike lasted for a considerable time. Under these circumstances, factors lowering exchange rate impact on inflation remained temporary. Third, we have to take into account if the weakening of the exchange rate impact shows signs of permanence. 

    Being understandable

    The fourth lesson is not specific to this policy, it is a broader one. For a new policy being understandable is critically important as its success depends on how it shapes the expectations of economic agents. Expectations for the future value of short-term interest rate affect the current exchange rate, interest-rate and stock prices. Alike, they shape the terms of future contracts, say price raises. They influence the credit supply and demand via impacts on banking and private sectors’ balance sheets. If the monetary policy is not well understood, it cannot be successful as it cannot influence the mentioned channels, no matter how successfully it is designed.

    The new monetary policy initiated in the late 2010 was not understood for a long time. Please note that, I am not interested in whether the policy is generally supported or criticized as long as it is understandable. CBT’s policy was not understood not only because it was new. More important was that multiple objectives were assumed and contradictory decisions were taken. For instance, the CBT increased reserved requirements and reduced the policy rate over the same time frame. It widened the interest rate corridor and let the market rate float around the policy rate. Such complexities must be avoided when designing monetary policy.

    This commentary was published in Radikal daily on 26.07.2012