The recent increase in Central Bank (CBRT) reserves, the continued decline in FX-protected deposits (KKM) and the fall in CDS rates are positive developments in terms of the stability of financial markets. The most important reason for this positive development is the CBRT’s decisive and increasingly stronger tightening steps in monetary policy.
What the Central Bank should do in the fight against inflation is to raise the policy rate above the 12-month expected inflation. Expected inflation should take into account not only the Central Bank’s expectations but also market expectations. Recently, the Central Bank’s forecasts have been quite realistic and market forecasts have been close to the Bank’s forecasts, which has had a positive impact on confidence in monetary policy.
Policy rate tends to intersect with market inflation expectations
In the inflation report released by the Central Bank in early November, the inflation forecast for 2024 was set at 36%. However, the Central Bank said that this was a midpoint and that inflation at the end of the year could be between 30% and 42%. Last week, the Central Bank surprisingly raised the policy rate to 40% and signaled that the hikes will continue for a while, which we believe shows the bank’s willingness to go above the top end of the forecast of 42%.
Accordingly, the policy rate could be raised by 250-300 basis points to 42.5%-43% in December. Such a rate would indicate that the Central Bank has both exceeded its inflation forecast at the upper bound and moved closer to market forecasts. According to the Central Bank’s November survey of market participants, 12-month inflation expectations fluctuate between 43% and 47%. In a sense, the Bank’s decision to bring the interest rate down to around 43% would create an intersection point with market expectations. Moreover, if these steps are strong, they may pull market expectations down a bit further, further strengthening the intersection point.
Wages will influence CBRT’s decision
We expect that the most important determinant of whether the CBRT will make a new decision on interest rates in January will be the wage negotiation process that will start in December and the wage increases that will take place in January. Since wage increases provide a significant pass-through to inflation, inflation forecasts may be revised upwards by a few percentage points by both the bank and market participants in case of stronger than expected increases. In such a case, the Central Bank may choose to raise the policy rate to 45% in January. On the one hand, this step reflects a preference to stay above expected inflation, but on the other hand, it may also serve to suppress the increase in demand that may arise from wage hikes and to channel some of these wages into savings through attractive deposit rates.
CDS could go towards 250
If the CBRT is able to maintain its stance, CDS rates, the country risk indicator, will continue to decline. For example, under normal conditions, Turkey’s CDS rate is close to South Africa’s. With the reversal of our monetary policy after September 2021, our CDS rates broke a record by reaching 800s and completely broke away from South Africa. Since June, the normalization in monetary policy has started to rapidly reduce CDS rates. We experienced a similar break and convergence in 2021 during Mr. Naci Ağbal’s short-term presidency of the Central Bank. Considering that South Africa currently has a CDS rate of around 250, our country’s CDS rates may soon fall below 300 and converge to 250 levels.
The normalization and simplification steps in monetary policy were also reflected in bond rates. Bond rates started to form at levels in line with the policy rate. The yield curve shifted downwards in line with expectations that inflation would fall in the long run. These developments indicate that the tendency for prices to be formed correctly in financial markets has increased and accordingly, expectations may become more rational.
Difficult without fiscal policy and structural reforms
All these developments summarized above show that monetary policy is positioned correctly in the fight against inflation and that results are starting to be achieved. However, the fight against inflation requires determination and continuity. It is absolutely necessary for monetary policy to continue uninterrupted and with the required strength. If budget balances are not normalized strongly and capital inflows from abroad are not strong enough, monetization to close budget deficits and the resulting inflationary pressure will be inevitable.
Despite Argentina’s relatively tight monetary policy, the fact that it had to finance its rising budget deficits through monetization due to its inability to achieve budget balances and external capital inflows prevented success in its fight against inflation. The Argentine example also contains an important lesson for us. In addition, the fight against inflation has a structural reform dimension. Reforms should not be considered only in the economic dimension, such as increasing competition in markets, but should be realized in a comprehensive framework ranging from education to law.
Public pricing drives the market
Finally, the alignment of managed and administered prices with inflation forecasts is crucial for success. For example, the revaluation rate of 58% for 2024 is much higher than the CBRT inflation forecast of 36%. At this point, it is of utmost importance for the public sector to increase its savings and align such directed and administered price increases with the inflation forecast in terms of expectations management and guiding the private sector. This is an important cause of inflation in Turkey, something that has been said for years but never materialized.
