Monday, March 2, 2009

Weekly Hurriyet Column: Alphabet inflation, misspelled monetary policy

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. One and a half months later, most economists still think that inflation will be an L, whereas I share the minority view with the IMF that it will be a V, albeit the uptick shorter than the downtick.

As the financial crisis was making its way to the real sector in the US, economists were using the alphabet to debate how the recession would shape out: While “U”, “V” and “W” were the popular letters, Roubini’s L won out at the end. In Turkey, we more or less know that inflation will also be an “L”, but we cannot agree on where the corner will be turned.

Inflation fell sharply late last year, as the very same commodity prices that had fuelled inflation to 12% collapsed. Helped by stagnant demand, inflation ended the year at slightly above 10% and despite a higher-than-expected outturn last month, was finally back at single-digit (9.5%) territory. The Central Bank (CBT) expects this trend to continue, seeing inflation in the range of 5.4%-8.2% with a 70% probability.

While I concur with the Bank that inflation is on a downward path, I would place my bets on the upper half of its forecast range. For one thing, the limited exchange rate pass-through so far, which is one of the reasons behind the CBT’s confidence, might be illusionary: While it is true that the recessionary environment is helping, the lack of the pass-through might be partly due to the inventory depletion in certain sectors. Moreover, with uncertainty on the IMF front and limited room for further local support for the lira, the exchange rate weakness is likely to be permanent this time around. Then, even a modest pass-through would add a few percentage points to inflation.

The CBT has been emphasizing lately that inflation could fall below its end-year target of 7.5%.
This is in fact not too different from my own outlook; I just see inflation stabilizing at a higher rate than the Bank. In other words, my “L” is somewhat smaller than the CBT’s. It is this large “L”, combined with its concern over the growth outlook, which has led the Bank to cut rates 5.25% since November. I agree with the Bank on its growth assessment; in fact, I have been writing on strong negative growth this year since November, when most analysts were still behind the curve. In addition, the CBT could turn out to be right on inflation, too. But regardless, I believe it has taken an unduly risk with little benefit.

First, as I anticipated two weeks ago, the impact of the last cut on benchmark rates has been limited, highlighting the limited ability of conventional monetary policy to affect longer-term rates and normalize credit markets in situations where the binding constraint is not the price of credit, as was (and to a certain extent still is) in the US, but the quantity. In a recessionary environment where more firms are likely to default (as evidenced in the upward trend non-performing loans), it will be the default risk not funding costs, that will be in the bankers’ minds.

Moreover, loose fiscal and monetary policy could prove to be a dangerous mix. Simple sustainability calculations reveal that a primary surplus of less than 2% would increase the golden ratio of debt to Gross Domestic Product, which could, after a certain point, bear on the country’s risk perception and therefore rates. Moreover, the accompanying higher Treasury borrowing would put further strain on the monetary transmission mechanism by crowding out private lending. If all these found their way to the exchange rate, not only the CBT’s disinflation plans would be disrupted, but the real sector’s deteriorating FX open positions would mean that many firms would find themselves in dire straits, as would their lenders.

The CBT has taken monetary policy to uncharted waters, hopping on the global rate-cutting bandwagon on disinflation winds. I hope they are watching for the reefs.

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