Turkey’s unorthodox monetary policy: time for a rethink?

Turkey’s policymakers will come under increasing pressure to raise interest rates and tighten fiscal policy once next week’s national elections are over, after receiving an unpleasant surprise in inflation data released just over a week before the vote.

Consumer price inflation rose 2.42 per cent month on month in May, more than double the expected increase, bringing the annual rate of inflation from April’s historic low of 4.13 per cent to 7.17 per cent.

The figures, released on Friday, will fuel fears that Turkey’s central bank is failing to stop the economy overheating with its unorthodox policy mix of low interest rates to deter capital inflows, and higher reserve requirements to rein in domestic demand.

“The May inflation print will focus even more attention on the credibility of monetary policy… with now both inflation and the current account positions flashing red lights and suggesting clearly that the economy is over-heating and that more strident policy action is needed,” said Tim Ash, economist at the Royal Bank of Scotland.

The surprise was largely due to a surge in food prices, up 13 per cent year on year. Food prices are always volatile, and especially so in Turkey, so analysts do not expect Friday’s figures to change the central bank’s inflation outlook or its policy stance.

But the timing is politically awkward, since food prices have a big effect on public perceptions of inflation. Their increase could also make it harder for the central bank to contain inflation expectations, which are already running well above the official target for inflation of 5.5 per cent at the end of 2011.

Investors have become increasingly uneasy about Turkey’s economic outlook, noting its swelling current account deficit and fearing that rapid growth in domestic demand – reflected in a credit boom – could be followed by a hard landing.

The central bank is expected to begin raising interest rates towards the end of 2011, but many investors would prefer it did so earlier – and although the public finances are in good shape, they would also like the government to tighten fiscal policy.

Ministers are hinting they may take steps in this direction. Ali Babacan, economy minister, said last week the government could save the proceeds of a tax amnesty that analysts expect to generate billions in extra revenue over the next three years.

“This is a kind of fiscal tightening and would surely help to curb domestic demand but it’s got to be explained well to the market,” said Yarkin Cebeci, at JP Morgan.

However, the central bank thinks its strategy is working and that its effects will soon be apparent. Murat Ulgen, economist at HSBC, said officials told analysts this week that the Turkish economy’s problem was “over-borrowing, not overheating” and that growth in production and consumer demand was already starting to cool.

“Markets may well accept waiting until during the summer months – hoping for high tourism receipts to positively affect Turkey’s current account, observing global growth and inflation developments, and generally giving the central bank’s policy on credit more time to work,” said Christian Keller, economist at Barclays Capital.

Others are more uneasy. “I can’t think of a major emerging market that is sailing closer to the wind than Turkey,” said Nicholas Spiro, of Spiro Sovereign Strategy. “The risks of a hard landing are growing by the day – not least because the [central bank] appears to be sticking to its guns as far its unorthodox policies go.”

Mr Ash said a recent visit to Turkey had left him with “little doubt that the current unorthodox policy… is having little real impact on the ground.” He added: “Turkey needs fiscal and monetary policy to be more aggressively tightened now, or the risk is that we will see a more marked market correction.”

via Turkey’s unorthodox monetary policy: time for a rethink? | beyondbrics | News and views on emerging markets from the Financial Times – FT.com.