My take on yesterday's MPC meeting: Capital Punishment

The folks at Hurriyet Daily News & Economic Review asked my opinion on yesterday's MPC meeting. Having always been the generous and practical type, your friendly neighborhood economist decided to share his views with all rather than one by posting them to this blog.

By the way, there is a good chance that this topic will make it to my HDN&ER column on Monday, so you may also be getting an extended preview by reading along.

First, make no mistake: The Bank is maintaining its policy stance, which we can decompose into three interrelated subsections: Economic recovery, inflation and the actual policy rate. On the first, the Bank states the following:

Recent data releases suggest that economic activity continues to recover with the support of domestic demand. However, it would take a long time before industrial capacity utilization rates return to their pre-crisis levels, due to weak external demand outlook.

While it is true that capacity utilization rates, or CURs, are still well below its pre-crisis levels, the NAIRCU, the non-accelerating inflationary rate of capacity utilization (there is no such term, it is the concept of the NAIRU applied to capacity utilization), is likely to have fallen as a result of the crisis. As a result, there might not be as much slack in the economy as suggested by the CU data.

The same goes for unemployment. The Bank says:

Although employment conditions continue to improve, unemployment rates remain at high levels.

Fair enough, but again, according to my calculations, the NAIRU is higher than before the crisis, and there is actually not that much slack on the employment front, either. I am aware that much of this boils down to the fact that the Bank's potential output estimate seems to be higher than mine. But in any case, other recent data are surely hinting at a robust recovery, as the Bank notes as well. In that sense, using CU and unemployment, the seemingly weakest links among the real sector statistics, appears as a bit of data cherry-picking. I wrote on the latest indicators and their meaning on Turkish economic recovery last week, so feel free to have a look there for a more elaborate discussion of these points.

As for inflation, the usual emphasis on core inflation is again there:

it is expected that inflation would be on a declining path in the forthcoming period, while core inflation indicators would remain consistent with the medium-term targets.

Again, fair enough, but as I argued in my Hurriyet column this week, there might be some spillover from food to core inflation in the coming months. All in all, the Bank is justifying its policy stance, which is unchanged, as the key sentence regarding that is virtually the same as before:

the Committee has reiterated that it would be necessary to maintain the policy rate at current levels for some time, and to keep it at low levels for a long period.

But all this is more or less business as usual. What makes yesterday's MPC meeting more interesting is that the Bank, for the very first time, is explicitly (i.e. in a MPC statement) worried about capital inflows and the current account widening/ strong credit growth that are its consequences:

Recent surge in capital inflows exacerbates the divergence between the growth rates of domestic and external demand, widening the current account deficit through rapid credit growth and increasing import demand and thus highlighting the risks regarding financial stability.

And how is the Bank responding to this threat? In two ways:

the Committee has decided to widen the gap between lending and borrowing rates by reducing the borrowing rates by 400 basis points. Moreover, observing the favorable developments in credit conditions, the Committee has indicated that it would be appropriate to proceed with the remaining measures outlined in the exit strategy.

The first measure has caused the greatest stir, and is solely responsible for the Daily News managing editor calling me during the Besiktas game. While it is certainly not as drastic as it looks, there is also more than meets the eye, or rather more than what reads in the MPC statement: While the Bank continues to encourage market participants to trade with each other rather than with through this sharp rate cut, the move is also geared towards discouraging capital inflows with overnight maturity parking in the money market. But it is not likely to fend off such capital flows a lot, as most of these overnight carry traders are likely to shift to government bonds. Therefore, we may see a fall in yields today as a a result.

As for the second measure, the Bank is simply saying it will hike the required reserve requirement on lira deposits by at least another 50 basis points, which would bring it back to or above the pre-crisis level of 6%. We will probably see this move this morning, in a couple of hours or so; if not, definitely after the Bayram.

But despite all the hype of the 4 percent cut in the overnight borrowing rate, I would argue that the most critical sentence of the announcement is the one right before, which is, according to the Bank, the raison d'etre of the rate cut:

the Committee has decided to allow overnight interest rates to diverge from the policy rate temporarily, when needed.

This means that when liquidity is tightened, overnight rates could remain above the 7 percent policy rate for some time. Now, why would liquidity tighten? In the Turkish market, there are seasonal effects such as end-month tax payments that cause a temporary liquidity squeeze. In addition, Treasury auctions could temporarily effect liquidity. But CBT policy could play a role as well: For example, the above-mentioned reserve requirement rate hike would squeeze liquidity. Or if the Bank decreased its one-week repo funding, liquidity would be tightened and overnight rates rise. As a footnote, note that although the Bank does not state it explicitly, the cut in the CBT's overnight borrowing rate is also likely to bring some volatility into overnight rates. In other words, not only the overnight interest rates would hover above the policy rate, they would also be much less stable. This would further discourage some hot money from a Turkey play, or at least induce them to steer towards government bonds.

And why would the Bank want a sharp rise in the overnight rates? Because it would somewhat curb loan growth; we are back where we started! In essence, the gist of yesterday's announcement is to take precautions against the risks regarding financial stability that have finally made their way into the MPC statement, but without actually hiking the policy rate...