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Don’t make promises you can’t keep
One way to end the erosion of monetary policy credibility is to state a higher CPI target.
One should either keep his or her promise, or make another one that he or she can keep. There is no middle way. Yesterday inflation figures for October were released. Consumer price inflation (CPI) was recorded at 7.7 percent. More importantly, headline inflation (l indicator) reached as high as 7.5 percent, significantly above the average in recent years.
Since 2006, monthly realization of annual CPI averaged 8.3 percent while headline inflation averaged 6 percent. The averages are close to the stated level over shorter timeframes, as well. For instance, CPI and headline inflation averaged at 7.9 percent and 5.7 percent respectively between January 2010 and today. There is an evident rigidity in CPI. The rates float around this remarkably high average and eventually move back to the average level. Under these circumstances, yearend inflation standing at a low level or below the level targeted by the Central Bank has no significance as it eventually rises back.
Central Bank’s yearend CPI target has been around 5 percent in the last couple of years and there is a considerable gap between realization and target. This is a critical problem as it damages the credibility of the monetary policy in effect. What I am questioning here is not simply CPI not being lower. Eight percent might be normal for you and high for others. I am in the second group; but that’s another matter of debate. What I am trying to stress is that for the last couple of years, CPI was realized at a rate around 8 percent whereas the target was around 5 percent. One way to end the erosion of monetary policy credibility is to state a higher CPI target, say 7 percent. Of course, this does not come without any consequence. It might give way to the perception that the Central Bank has given up its anti-inflationary efforts, hence pushing up the expected CPI. This means higher wage raises, interest rates and price inflations in future contracts to come. If misinterpreted, increasing the CPI target to 7 percent might push up the CPI average I quoted above, eventually reproducing the current gap between the realization and the target. In that case, not only the plan works but also it pushes up inflation further. On the other hand, there will be an upwards pressure on the exchange rate for a few years ahead. The main reason is that the Federal Reserve will gradually halt its monetary expansion policy. Before the FED meeting last week, the expectation was that the policy reversal will be initiated in March 2014. After the meeting and relevant remarks, it is now a higher probability that the operation will take start in December. Interest on 10-year US Treasury notes might give hints of the repercussions of the FED operation on Turkey. Currently the rate is 2.6 percent. Should the US economy get back to normal, the rate will be slightly above 4 percent. This entire process implies a decline in capital inflows towards Turkey and similar countries. This is why we expect an upwards pressure on the exchange rate. Please note that this pressure does not have to be permanent; but the main trend seems to be in that direction.
Taking all these into account it seems unlikely that CPI will permanently stand below the rate it has floated around since 2010, at 7.9 percent. Revising CPI target upwards might be a good option provided that it is well communicate. Of course it is more desirable to actually lower the CPI close to the targeted level. No, I am not talking about remarks that read “Don’t worry. CPI will converge with the target in the medium-term.” What I am talking about is actually reducing inflation.
This commentary was published in Radikal daily on 05.11.2013