Monday, August 3, 2009

Weekly Hurriyet Column: Something’s gotta give

Below is the unedited version of my column for this week. You can read the final version at the Daily News website. As I noted from the comfort of a sailboat a few days after the column was published, it is the markets that are giving in at the moment. I hope this lasts...

The Central Bank (CBT) shattered my resolve to devote two weeks to long-term structural issues in tourism and industry with its latest Inflation Report.

While a continuation of the Bank’s dovish stance was the consensus view even before the summary of the Monetary Policy Council (MPC) minutes was released, last week’s report is as dovish as it gets. The Bank’s base scenario sees policy rates steady until the end of next year after some more easing. In fact, with the implementation of a medium-term sustainable fiscal framework, rates could be in single-digit territory for up to three years.

The Bank’s economic rationale is clear: Both the world and Turkey are to recover very slowly. Not only sustained low global rates are one of its key assumptions, the CBT has also revised down its domestic growth forecasts. However, the Bank (and many economists) sees a strong recovery in the output gap for 2010, which could put some pressure on inflation and consequently on policy rates. Nevertheless, there are other reasons for the Bank’s stance.

A former MPC member used to joke that his CBT ID had a Treasury Personnel stamp on it. With almost two thirds of the August Treasury redemptions of TRY 25 billion coming this week, this gag has taken on an entirely new meaning. With a seasonally high primary surplus and its coffers full, the Treasury’s hand would have been strong even without CBT support. But the planned rollover ratio of slightly less than 100% could be exceeded at this week’s auctions with very strong demand and record-low rates, allowing the Bank to build its war chest further.

The sustainability of these low rates or whether they will be able to affect the real economy are entirely different matters. On the former, the Bank has made it clear that market rates are out of sync with its policy outlook. Despite the strong rallies after the Inflation Report, both Treasury yields and cross currency swaps are still pricing in higher rates a year on and for end-2009. With survey expectations having penciled in a full percentage point rate hike in the next 12 months before the Inflation Report, this week’s survey has suddenly come to the spotlight.

The CBT is not the only Central Bank faced with this problem. Despite Bernanke’s latest assurances, markets are pricing in rate hikes of 1.5% until the end of next year, and long-term rates are still very high. This has led the chairman to a roadshow, as he has been appearing at anything from 60 Minutes to a Kansas City town hall. His failure would violate one of the key assumptions of the CBT. You can see the CBT Inflation Report as a similar effort to talk rates down.

The CBT’s job is arguably tougher than the Fed, as markets are not buying into its long-run inflation outlook, either. While both the Bank and markets see end-year inflation at around 6%, their projections move in opposite directions after that. This week’s expectations survey will be important in that respect as well.

But my real worry is not expectations. There is now a serious risk that these measures could backfire. Not only the Bank is running, without a credible fiscal framework, the risk that its stance will be perceived as fiscal accommodation or debt monetization, it could also lead to asset price bubbles a la Turca, with the banking sector and bonds being the obvious candidates. Dollarization would be another consequence, which would ease the pressure off the lira a bit, but at the expense of some dear liquidity.

At the end of the day, with so much out of sync, either the CBT or the markets will have to give in. In case it is the Bank who ends up caving in, I have two suitcases packed so that I can close shop and leave for an exotic island right away.

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