ANKARA - "Given the prevailing uncertainties over the medium term outlook, monetary policy needs to remain tight to ensure the convergence to medium term targets," the Turkish Central Bank said on Monday.
Central Bank Governor Durmus Yilmaz and Deputy Governor Erdam Basci sent an open letter to State Minister Ali Babacan and the International Monetary Fund (IMF) pursuant to Article 42 of the Central Bank Law.
The letter says, "although the accumulated impact of the various cost-push shocks combined with the continued exchange rate pass-through has kept inflation at high levels, the policy we have conducted since June 2006 has been successful in containing inflation and inflation expectations."
"Inflation is already down to single digits from its peak of 11.69 percent in July 2006; however, it is still significantly above the medium term target of 4 percent. Given the prevailing uncertainties over the medium term outlook, monetary policy needs to remain tight to ensure the convergence to medium term targets. That is why, we will conduct monetary policy with a tightening bias in the period ahead. In other words, monetary policy will stay more attentive to adverse developments than favorable developments regarding inflation outlook. This approach reflects our commitment to achieving the medium term inflation target," it said.
"It should be stressed that an appropriate monetary policy is a necessary but not a sufficient condition for achieving long run price stability. Attaining high primary surpluses have been central for the disinflation process in the past years. Maintaining and advancing the gains achieved thus far requires the continuation of the European Union accession process, and the implementation of structural reforms that would ensure the sustainability of fiscal discipline in the long run," it said.
The letter noted, "we expect aggregate demand conditions to support the underlying disinflation process in the next couple of quarters. Although the exports are likely to grow faster than the imports in the first half of the year, our projections suggest that the modest growth in the private domestic demand will continue to hold the GDP growth rate at levels below the previous years. We envisage that the non-accommodative monetary conditions and the slowdown in economic activity will limit the second round effects of the supply shocks witnessed in 2006."
"Another factor that could contribute bringing inflation down in 2007 is the high base created by the supply shocks cited above. The normalization of food, energy and other commodity prices together with the disappearance of the base effect of exchange rate pass-through have the potential to drive a sizeable reduction in annual inflation, especially starting from the second quarter of 2007," it said.
"Inflation in services prices has been quite persistent, possibly due to the presence of backward-looking pricing behavior and relatively low productivity in the services sector. Also, the recent pension and minimum wage increases together with the civil service wage hikes put an upside pressure on services and overall inflation," it said.
-INFLATION FORECAST FOR 2007 AND 2008-
The letter noted, "against this background, bringing inflation back to the target of 4 percent necessitates a tight policy stance. Assuming that the policy rate is unchanged for the next three quarters and gradually eased thereafter, we forecast inflation to be between 3.6 and 6.6 percent (mid-point 5.1) at the end of 2007 and between 1.6 and 5.2 percent (midpoint 3.4) by the end of 2008, with 70 percent probability. We expect the downward trend in inflation to become more pronounced in the second and third quarter of 2007. Our projections suggest that it may take around 5 quarters to converge to target. It should be stressed that both the inflation forecast and the underlying policy path is conditional on the currently available information, and therefore, subject to change as new information arrives."
-RISKS-
"The main risk factor for the medium term inflation outlook can be listed as higher-than-expected inflation inertia, as currently manifested in the medium term inflation expectations. Given that we plan to bring inflation down from 10 percent to 4 percent in a fairly short period of time, the degree of stickiness in services inflation emerges as a major risk to our forecast, especially if one considers the recent real wage awards. Realization of such a risk could require keeping the tight policy stance longer than envisaged in our baseline forecasts. Accordingly, we will continue to keep a close eye on the services price inflation along with various core inflation measures," it said.
"Another risk for the inflation outlook is the uncertainty regarding impact of monetary policy on the aggregate demand. Lags in monetary policy transmission are time variant, and the Turkish economy is no exception," it stressed.
The letter noted, "the sizeable slowdown in the third quarter of 2006 was a result of lower confidence due to financial market volatility in May-June period, rather than an outcome of tightened monetary policy. Although the tightening exercised since June 2006 started to be effective on the interest-sensitive private demand recently, the extent and the duration of the slowdown in the overall economic activity remains to be seen. Uncertainties are also related to the behavior of government spending, which could represent an upside risk to the aggregate demand, and therefore inflation in 2007. In this respect, the MPC has been closely monitoring the macroeconomic impact of the developments in the incomes policy as well as the public sector non-interest expenditures."
"A third risk factor that may put delay in attaining the medium term targets is the possibility of a sudden change in the global financial market sentiment. Global liquidity is still the major factor in shaping risk appetite and volatility in financial markets. In case the deterioration turns out to have lasting effects on the medium term inflation outlook, the MPC will revise the borrowing rates upwards," it said.
"It is worth to note that, not all the scenarios regarding the global outlook are unfavorable for our economy. Turkey is a net commodity importer. Although a slowdown in the global economic growth or a further easing in commodity prices could have an immediate adverse impact on the domestic inflation through its impact on the global risk appetite, it will also lead to a positive terms of trade shock and thus to a more favorable outlook in the medium term," the letter added.