Monday, February 1, 2010

Weekly Hurriyet Column: The Missing in the Inflation Report

Below is the unedited version of my column for this week. You can read the final version at the Daily News website. I again have a movie reference, but not a very famous one. BTW, at 2.6 percent mom, Istanbul Chamber of Commerce January inflation lent some weak (because the two indicators are not perfectly correlated) support to my higher-than-expected inflation call. As for my worse-case scenario, I would definitely not call it stagflation, as the economy will still be growing and inflation is unlikely to reach double digit territory (I see the apex slightly below that at late spring-early summer), but I can definitely live with stagflation-lite. As for the bank lending channel I have described numerous times, I have the perfect video that depicts the mechanism, but but I have to run now...

The Central Bank, or CBT, released the first Inflation Report of the year last week.

What is in the report has been well-covered by the media. To recap, while the Bank continues to play down the recent and expected rise in inflation, it nevertheless revised up its year-end projection from 5.5 to 6.9 percent, mainly due to one-off inflationary items such as tax and administrative price hikes.

Such price increases were evident in the government’s Medium-Term Economic Program, when the revenue figures did not add up, so the only explanation for the delay in the Bank’s forecast update seems to be expectations management. Incidentally, the Bank is struggling on that front, as inflation expectations continue to creep up. Wednesday’s inflation, which I expect to come a good 0.5-1 percent higher than market expectations of 1.3 or 1.7 percent, is likely to deal another blow to that battle.

Leaving this small digression aside, what is really interesting is not what is in the report, but what is not, so there is some room for me to create value added, after all. For one thing, the downside risk to the policy rate of a significant pick-up in capital flows has been dropped. Not that I am complaining; it had seemed to me more like a flying pig in the first place, but its removal might have something to do with the uncertainty on the IMF front.

But if the CBT does not expect significant capital flows to Turkey this year, it should have articulated how it will take care of the probable accompanying liquidity squeeze, on which there is not much in the report. While many commentators see it as a Turkey-specific case, the link between a Central Bank’s ability to create permanent liquidity and international reserves accumulation from capital inflows is a common emerging market phenomenon.

Some countries have been able to break this vicious circle by de-dollarization and increasing the maturity of domestic currency assets, but in the short-run, the CBT will have to undertake an even more aggressive temporary liquidity provision via repo auctions. But I am not sure this will be a big help, as the Treasury’s heavy domestic redemptions are likely to continue to steer banks away from credit, which will, in turn, delay the economic recovery, as the real sector starts to get more and more credit-constrained.

All this points to a worst-case scenario of inflation heading up due to worsening expectations, tightening domestic liquidity and slower-than-expected domestic recovery. This environment will also affect the CBT’s ability to remain on hold.

The Bank has abandoned its insistence that it will hold rates constant this year in favor of a longer-term horizon: It now says that policy rates will remain in single-digit territory in the next three years. We all know that the Bank will try to postpone rate hikes as long as possible, but most commentators believe that if push comes to shove, the CBT will first resort to liquidity tightening measures. This challenging outlook all but rules out a liquidity squeeze response to inflation.

A Stand-by with the IMF would be very useful in this setting, as the funds would be used to bring down the 100% domestic debt rollover ratio, in effect releasing more credit funds to the real sector. So it again boils down to how the IMF-Turkey saga will end. On that, it is comforting to know that CBT President Durmus Yilmaz is as in the dark as the rest of us regarding the fate of the agreement.

But the government has been managing expectations quite well on that front so far, with rumors of an IMF deal coming at times of market volatility or before important Treasury auctions. Maybe, the CBT could learn expectations management from the government.

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