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    Condemned to the average

    Fatih Özatay, PhD07 November 2013 - Okunma Sayısı: 1003

    You can take a month of low inflation and proudly say “we achieved the lowest inflation ratio of the last something years” for instance.

    I want to share a figure; it will best illustrate what I am trying to tell. It shows monthly inflation realizations since 2009 – there is no need to go back further. The horizontal line represents the average consumer price inflation (CPI) since 2009: 7.6 percent. It is clear that the average level pulls the CPI like a magnet: the levels above and below the mean value prove temporary. The CPI fluctuates around the average line. There is a technical terms for this: mean reversion. If you jump into another literature, you come across the term “inertia” for a similar concept.

    It is all fine if you are okay with the average. After all, that is where you will end up sooner or later. You can even invent word games for those who are unhappy with the average. You can take a month of low inflation and proudly say “we achieved the lowest inflation rate of the last something years” for instance. Your word game would become extremely popular if the month you are quoting is December: people might not always be able to “see” what needs to be seen. And as the last month of the year, inflation figures for December are popularly quoted.

    Figure 1: CPI and average CPI: January 2009 – October 2013 (annual, %)

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    Source: TURKSTAT

    But there is a completely different story if you are not happy with the average. In that case, you have to be concerned about whether or not inflation trend line is heading down; not about individual monthly figures. Therefore, considering mean reversion, achieving a remarkably low level of inflation in a single month has no significance, except for one particular case: if the country pursues a strong policy that will overcome the mean reversion in inflation, the probability that below-the-mean episodes turn out to become permanent strengthens.

    In 2012, monthly CPI average was 8.9 percent. In the first ten months of 2013, it was 7.5 percent. There are a couple of sings that CPI will trend up in the months ahead:

    There is no economic policy in place that will overcome the mean reversion of inflation. The upwards trend in exchange rate since May has not been translated onto inflation dynamics.

    Average headline inflation (the l index) is currently 2.3 points lower than the CPI average. Yet, the former has been in the rise since April, finally reaching 7.5 percent in October. This implies that we should expect an upwards pressure on CPI in the months ahead.

    The mean trend in exchange rate will be upwards in the light of possible decisions the Federal Reserve is expected to announce by the end of this year or in early 2014.

    This commentary was published in Radikal daily on 07.11.2013

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