The effects of the Central Bank’s tight monetary policy started to be seen. While inflation has fallen to 2.5 percent from 3.0 percent, markets are lowering their inflation forecasts. The 12-month-ahead inflation forecast has fallen from 45 percent to 39 percent in the past three months.
In a base case scenario where the Central Bank keeps interest rates at these levels until the last quarter of the year, we would normally expect actual inflation and expectations to continue to decline.
But unfortunately, normal conditions do not apply. We are faced with three main dynamics that make it difficult for monthly inflation figures to decline: expansionary income policy, expansionary fiscal policy, and the necessary hike in electricity prices after the local elections.
In order to correct pricing habits and inflation expectations that have deteriorated over the last three years, contractionary incomes, and fiscal and monetary policies need to be implemented.
However, it is not possible to implement a contractionary fiscal policy in a country hit by an earthquake. Contractionary revenue policy before the elections is contrary to realpolitik. Therefore, Turkey is trying to control inflation with an economic policy shaped on one of the three pillars.
The first half of 2024 will be a difficult period in the fight against inflation despite the contractionary monetary policy. In the first months of the year, inflation will remain high due to wage increases, collective bargaining results, the rise in electricity prices after the local elections, and backdated contracts.
Expansionary fiscal policy is another reason that makes it difficult to fight inflation. In 2023, Turkey posted a budget deficit of around 5.6 percent of GDP and a primary deficit of around 2.8 percent.
The fact that the budget deficit is 2.2 times higher than the cash balance is another problem that needs to be managed. The public sector has about TRY 750 billion in accrued but unpaid debts. If some of this amount is paid with the cash available in the first months of the year, the market will be provided with significant liquidity.
For monetary policy to be effective, the Central Bank needs to be a net lender to the markets. Currently, the Central Bank is trying to withdraw excess money from the markets. This reduces the effectiveness of monetary policy.
In order to dissolve excess liquidity within the market mechanism, the Treasury needs to increase its revenues, cut spending, or increase domestic borrowing. If excess liquidity remains in the market, the Central Bank will need to increase the weekly repo rate.
In the medium term, the solution will be achieved by harmonizing revenues, and fiscal and monetary policies to achieve the same objective.