Turkey: The New Monetary Policy Approach and Its Implementation

The Turkish economy has displayed rapid recovery driven by domestic demand,while external demand folowed a relatively weak course in the post-crisis period.By mid-2010, the high growth rates in emerging economies, including Turkey, aswell as the expansionary monetary policies in the U.S. economy and theEuropean economies led to massive capital inflows to emerging economies.

The surge in capital provided easier access to credit, and thus, acceleratedconsumption spending and also led to the appreciation of the Turkish lira, therebywidening the imbalance between domestic and external demand. The rapiddeterioration of the current account and the growing share of short-term capitalinflows and portfolio investment in net capital inflows increased the economy’sexposure to sudden changes in global risk appetite, thus, warranting analternative policy approach against mounting concerns over macroeconomicand financial stability.

The CBRT, in order to contain the accumulated macro financial risks, adoptedthe objective of slowing down credit growth and reducing short-term capitalinflows as intermediate targets. Accordingly, as of November 2010, the CBRT,without sacrificing price stability, has launched the new policy mix of interest ratecorridor and required reserves ratios, in addition to policy rates, in order toobserve financial stability.

In order to limit credit growth, required reserve ratios have been used within thenew policy mix. In this context, the CBRT announced on its exit strategy in April2010 that it would raise TL and FX required reserve ratios to pre-crisis levels, anddelivered gradual hikes. Furthermore, interest payments on TL required reserveswere terminated, the coverage of the liabilities subject to reserve requirementwas extended, and both TL and FX required reserve ratios were differentiated bymaturity, with higher ratios for shorter term maturities.

Meanwhile, with the objective to limit short-term capital inflows, the CBRT’sintermediate target, 1-week repo rate, the policy rate, was reduced by 75 basispoints to 6.25 percent, and the O/N borrowing rate was reduced by 500 basispoints to 1.5 percent. Again for the same objective, interest rate corridor waswidened further, thus enabling an operational framework that allows to adjustshort-term volatility in money markets to economic conjuncture.

Communicating the Monetary Policy

Although it looks quite complicated at first sight, the newly adopted policy mix isnot different in spirit from the conventional inflation targeting framework. The maindifference from the previously implemented policy is observing financial stability inaddition to the main objective of price stability, and thus, using required reservesand effective liquidity management as supportive tools, in addition to 1-weekrepo rate, the policy rate.

Within the new policy mix framework, just like in the inflation targeting framework,the deviation of the inflation forecast from the target is the main criterion with theonly exception that non-interest tools are also employed in order to observemacro financial imbalances. Accordingly, the monetary policy stance dependson short-term policy rates as well as monetary conditions such as market liquidityand required reserves. The issue of which policy instrument will be used howdepends on factors affecting financial stability and price stability.

The increased emphasis of the CBRT on financial stability may lead to perceptionsthat price stabiliy has been neglected. With this awareness, the CBRT establishedan effective communication and underscored the overriding objective of pricestability through policy documents on all occasions. Moreover, the CBRT alsoreminded that overlooking macro financial imbalances under currentcircumstances would hamper price stability in the future. In order to preventpossible deterioration of expectations due to the change in the objectivefunction, the CBRT adopted a cautious stance regarding inflation, andhighlighted the need for monetary policy tightening.

The absence of a widely accepted theoretical foundation for the transmissionchannel of unorthodox tools like interest rate corridor and required reserves mayalso hamper communicating a monetary policy strategy where these tools areactively used. In order to prevent expectations to deteriorate due to uncertaintiesabout transmission mechanism, the CBRT frequently highlighted through policydocuments that the impacts of these meaures would be carefully monitored, andadditional measures would be adopted if deemed necessary.

Within the inflation targeting framework, the CBRT publicly shares its inflationforecasts through Inflation Reports and announces the qualitative course of thefuture policy rates. By the adoption of the new policy strategy, the CBRT, insteadof announcing the future course of policy rates, communicated the monetarypolicy strategy through policy mix and “monetary tightening”. Accordingly, with aview to maintain the flexibility regarding the future course of instrumentscomposing the policy mix, the CBRT, rather than providing the direction for eachindividual instrument, announces its forecasts on the net impact of the policy mix.In doing so, the CBRT also enhances the effectiveness of the required reservesthrough interest rate risk channel by reducing the forecastability of short-termpolicy rates, one of the components of the policy mix.

The CBRT has followed an open communication strategy about the limits of themonetary policy. The CBRT, thus stated that, reserve requirement is one of thetools to limit credit growth and domestic demand, and supportive measures byother relevant institutions are vital for containing macro financial risks. It wasfurther stated that direct measures for limiting credit growth would enhance theeffectiveness of the CBRT’s policies.6 In other words, for the effectiveness of thepolicy mix, the importance of fiscal discipline as well as supportive regulations byother relevant institutions were underscored.

The preliminary results of the policy mix indicates that the new approach isappropriate in terms of limiting macro financial risks imposed by short-term capital inflows. The CBRTwill continue to jointly use short-term policy rates in addition to non-interest tools inorder to build price stability on a permanent basis, while also observing financialstability from a macro perspective.

In sum, the newly adopted monetary policy by the CBRT is country-specific andtailored to current economic climate. The CBRT, by emphasizing financial stability,has focused on current account, the quality of financing and credit growth.

In other words, the emphasis on financial stability encompasses a macroperspective and reflects a period-specific communication strategy. Therefore, inthe upcoming period, macro financial risks may be highlighted through othervariables.

SOURCE: CENTRAL BANK OF TURKEY