inflation targeting, policy rates and exchange rate volatility: evidence from turkey

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Page 1: Inflation Targeting, Policy Rates and Exchange Rate Volatility: Evidence from Turkey

Symposium Paper

Inflation Targeting, Policy Rates andExchange Rate Volatility: Evidencefrom Turkey

CEM AKYUREK1 & ALI M KUTAN2

1Istanbul, Turkey. E-mail: [email protected] of Economics and Finance, Southern Illinois University Edwardsville,Edwardsville, IL 62026-1102, USA. E-mail: akutan@siue,edu

In January 2002, the Central Bank of Turkey (CBT) moved to an implicit inflation

targeting framework, which included core attributes of an inflation targeting (IT)

regime including, among other requirements, the announcement of a formal target

for inflation. As a result of successful disinflation, prudent fiscal policy and

implementation of reforms, Turkey introduced a full-fledged IT regime in 2006,

which brought further transparency to the monetary policy framework. We found

that during 2002–2006, among other factors, the developments in Turkey’s risk

premium played a very significant role in the path of policy rates. We arrived at this

conclusion by estimating a Taylor rule describing the policy reaction function of the

CBT. During this period exchange rate pass-through to inflation declined, and while

capital inflows strengthened the real exchange rate, the nominal exchange rate and

the financial markets in general were affected by occasional reversal of capital

inflows. We offer a short discussion of CBT reaction to sudden stop episodes under

the new monetary regime. Particularly, we ask whether the sharp increase in policy

rates in response to the mid-2006 episode was a defense of the currency instead of

adherence to an open economy IT regime. We also discuss whether softening of the

targeted disinflation path may have been a viable option.

Comparative Economic Studies (2008) 50, 460–493. doi:10.1057/ces.2008.23

Keywords: inflation targeting, central banks, Taylor rule, Turkey

JEL Classifications: F3, E5

Comparative Economic Studies, 2008, 50, (460–493)r 2008 ACES. All rights reserved. 0888-7233/08

www.palgrave-journals.com/ces

Page 2: Inflation Targeting, Policy Rates and Exchange Rate Volatility: Evidence from Turkey

INTRODUCTION

Facing a sudden reversal of capital inflows, Turkey had to exit from its 13-month-old exchange rate peg and adopt a floating exchange rate regime in February2001. The after effects were devastating, as the nominal exchange rate nearlydoubled in 2 months, inflation more than doubled in 6 months and the economycontracted significantly with the collapse of the banking system. The crisis led toa new economic programme funded by the IMFand a new approach to monetarypolicy (Akyurek, 2006). Accordingly, in January 2002 the Central Bank of Turkey(CBT) began implementing an implicit inflation targeting framework (IIT), whichencompassed core attributes of an inflation targeting (IT) regime including,among other requirements, the announcement of a formal target for inflation.Coupled with fiscal discipline and economic reforms, under the IIT framework,inflation declined from over 70% to below 8% by year-end 2005 while the CBTconsistently outperformed its year-end point targets measured by the consumerprice index (CPI). In due course, the CBT cut its overnight policy rate from 59%to 13.5%. It seemed more or less that during this period of disinflation, structuraltransformation and transitional dynamics, the CBT was searching for anequilibrium real interest rate commensurate with lower inflation.

Given successful disinflation, improvements in fiscal conditions and thebanking system in particular, the CBT introduced full-fledged IT at thebeginning of 2006, which brought further transparency to the new frame-work. During the first year of full-fledged IT, year-end inflation (9.86%)exceeded the target (5%) by a wide margin. The year saw a sudden reversal ofcapital inflows in May–June mainly driven by the deterioration in investorsentiment towards emerging markets in general. The exchange ratedepreciated by close to 30% and the CBT raised its policy rate from 13.25%to 17.50%. While inflation returned to pre-shock levels after about a year, itremained above the path leading to the 4% year-end target set for 2007.

In this paper, we focus on Turkey’s inflation targeting regime. Turkey’sexperience is important for several reasons. First, literature on inflationtargeting mainly focuses on developed countries.1 More recently, somedeveloping and emerging markets have adopted a regime of inflationtargeting and their experience is examined by some recent studies.2 Many

1 Recent studies include Brimmer (2002), Dodge (2002), Johnson (2002) and Carare and Stone

(2006).2 For individual country experiences, see Brash (2002) and Honda (2000) for the New Zealand;

Armenio et al. (2003) for Brazil; and Torres (2003) for Mexico. Amato and Gerlach (2002) provide

evidence from many developing countries and emerging markets. More recently, Goncalves and

Salles (2008) provide evidence from 36 emerging markets and they find that those countries that

followed an IT regime did have a better economic performance than those that did not.

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new member states of the European Union (EU) have also adopted inflationtargeting regimes.3 However, there is scant work on inflation targeting regimefor Turkey. We believe that Turkey’s experience may provide valuable lessonsfor emerging European and other developing economies. In addition, Turkeyis a candidate for the EU membership, and inflation targeting is consistentwith the Maastricht criteria for joining the European Monetary Union.

The paper has three simple objectives. Firstly, in the second section, weprovide a short description of the IIT period in Turkey including a discussionof the evolution of the new monetary framework and the conditionsprevailing during the period of its implementation. Here we emphasise thechallenges facing the conduct of monetary policy in this new environmentand also discuss the changes to the framework with the transition from IIT toIT. The third section provides a discussion of theoretical issues concerninginterest rate policy in small open economies under the IT regime. The sectionprovides a brief discussion of monetary transmission with an emphasis onissues concerning the dynamics of monetary channels in emerging marketsand implications for monetary rules. The fourth section provides a discussionand empirical analysis of the path of policy rates in Turkey where the maindrivers of policy changes seen under the new framework are formallyinvestigated. As such, a Taylor rule is estimated for 2002–2007. In the sectionExchange rate pass-through, capital inflows and monetary policy: 2002–2007,the results of an empirical analysis of exchange rate pass-through to inflationis presented, including an investigation of changes, if any, in the process sincethe introduction of IIT. The next subsection includes a brief discussion ofmonetary policy reaction to sudden stops during 2002–2007. Concludingremarks are presented in the last section.

THE NEW MONETARY POLICY FRAMEWORK AND PRELIMINARYCHALLENGES

The literature provides a long list of requirements that countries should meetif their IT framework is to operate successfully.4 Some are structuralrequirements and seem more IT-specific when taken as indispensable partsof the framework. These include (i) public announcement of medium-terminflation targets; (ii) institutional commitment to price stability as the primary

3 The following studies study the experience of the new member states: Amato and Gerlach

(2002), Siklos and Abel (2002), Jonas and Mishkin (2003), Golineli and Rovelli (2005), Orlowski

(2004, 2005) and Orlowski and Rybinski (2006).4 See Schaechter et al. (2000), Jonas and Mishkin (2003) and Carare et al. (2002) for a

discussion of requirements for a successful IT regime.

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goal of monetary policy, to which other goals are subordinated; (iii) increasedcommunication with the public and markets about the plans and decisions ofthe central bank; and (iv) increased accountability of the central bank forattaining its inflation objective. In this context, Mishkin (2000) emphasisesthe finding that IT entails much more than a public announcement ofnumerical targets for inflation for the year ahead and that it is particularlyimportant for emerging market countries to establish all other conditions iftheir IT regimes are to be sustainable over the medium term. The IT regimehas the potential to reduce the likelihood that the central bank would fall intothe time-inconsistency trap if it increases transparency and the accountabilityof the central bank, particularly for emerging market countries with a longhistory of monetary mismanagement and credibility issues. Other require-ments often cited for a successful IT regime, which seem as desirable featuresfor successful operation of all available monetary policy frameworks, include(i) a strong fiscal position; (ii) a well-developed financial system; (iii) areasonably well-developed ability to forecast inflation; and (iv) a wellunderstood transmission mechanism between monetary policy instrumentsand inflation.

The new monetary framework of Turkey was introduced as part of acomprehensive IMF-supported economic programme following the February2001 crisis during which the exchange rate peg was replaced by a floatingexchange rate. For the balance of 2001, a transition period before the IIT, IMFprogramme monetary performance criteria were set as quantitative limits onnet domestic assets (NDA) and net international reserves (NIR). Yet, anindicative target was set for base money, which the CBT indicated wouldbe the main operational target of monetary policy during 2001. With thecommencement of the IIT framework in 2002, the overnight interest ratebecame the operating target while monetary indicators also remained asperformance criteria and indicative targets.

Turkey’s IIT regime encompassed many of the core institutional attributesof the full-fledged IT framework. Multi-year point CPI inflation targets wereannounced and new legislation gave legal independence to the CBT, asachieving and maintaining price stability was declared as its primaryobjective. The CBT was also fully authorised to choose its monetary policyinstrument. Communication with the public, transparency of monetary policyand accountability of the CBT improved significantly with the establishmentof a monetary policy committee (MPC), communication of the rationale forpolicy changes through press releases, the start of regularly publishedinflation and monetary policy reports and frequent public appearances byCBT officials. Inflation targets were announced as 20%, 12% and 8% for2002, 2003 and 2004, respectively, based on the CPI index after inflation had

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declined to 29% at end-2001 for which the official projection was 35%. Theadvantage of setting the target on broadly defined headline inflation was thatit is better understood by the public, while the disadvantage was that itsmovement could reflect factors other than monetary policy measures, andcould be a more difficult target to hit. The CBT preferred to set CPI targets butalso relied on narrowly defined indices of inflation, such as those excludingsupply shock effects, to assess the path of inflation and to communicateinflation conditions to the public.

The unfavourable economic developments that forced Turkey out of itspeg and motivated the shift to an IT-like regime posed risks for its credibility.Recurrence of factors that led to economic crises could force monetary policyto subordinate the newly established inflation objectives. In this respect, therewere some key features of the economy in general and characteristics ofinflation dynamics in particular were significant obstacles to the success ofthe new monetary regime at the onset. Turkey had suffered from high andvolatile inflation, as average inflation over the past 20 years had registered at61.5% with a standard deviation of 26%. Inflation had a strong fiscalcomponent, and yet several studies of its dynamics indicated the existence ofa strong inertial component, which had progressively strengthened over theyears. Additionally, movements in the exchange rate had a profound effect oninflation due to high pass-through from the former to the latter and monetarypolicy had accommodated several external shocks over the past twodecades.5 The exchange rate-based stabilisation programme introduced inJanuary 2000 failed to achieve the intended results on the inflation front andthe forced exit from it resulted in a more than doubling of the nominalexchange rate within a couple of months, which raised inflation to 74% at thebeginning of 2002 from 36% at end-2000. Inflation targeting frameworks hadnot been used to engineer major disinflation from a starting point of highinflation and in this respect the practice of IT in Turkey would be a challenge.

Schaechter et al. (2000) emphasise exchange rate stability as beingimportant for the successful operation of IT regime and, in this context, arguethat stability can be defined as a policy framework with an exchange ratevalue credible enough to convince the markets that the inflation target willnot be threatened by currency crisis. The sharp real depreciation in theaftermath of the 2001 crisis and the role IMF support would play to weatherpressures on the currency going forward were two factors that provided somecomfort regarding stability in the exchange rate at least initially. Yet, pastexperience with capital inflows and exchange rate volatility was concerning.

5 For an analysis of the role of exchange rate movements and in particular of external shocks on

inflation dynamics, see Akyurek (1999).

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As such, capital inflows (outflows) have been the catalyst for booms (busts),as evidenced by the correlation between net capital movements, exchangerate movements and GDP growth over the past several years. Episodic capitalinflows relieved the fundamental foreign exchange bottle neck of theeconomy, cheapening imports of essential intermediate products, andfacilitating an expansion of the domestic financial system and bank credit,which led to periodic outbursts in growth. These episodes were unequi-vocally followed by a sharp weakening in the exchange rate, higher inflationand lower growth.

The fiscal conditions at the start of the IIT framework certainly provided achallenge for monetary policy. Prior to the 2001 crisis, and even more so inthe aftermath, the level of public sector debt and concerns regarding itsrollover had become the focus of markets. Bonds issued to recapitalise thebanking system, the sharp fall in output and rising real rates caused thepublic sector debt ratio to rise sharply. Additionally, the Treasury issued largesums of foreign exchange denominated and linked bonds as well as floatingrate notes, which increased the sensitivity of debt service to fluctuations inshort-term interest rates and exchange rates.6

The government responded to rising real interest rates following the crisisby doubling the public sector primary surplus (to over 6% in 2001 and 2002),and IMF funding helped significantly to allay rollover concerns. Yet fiscaldominance remained a challenge for the new monetary regime. In the periodfollowing the commencement of the IIT regime, there were several episodes ofdramatic change in market sentiment and overall expectations of economicagents evidenced by the size and frequency of volatility in domestic bondyields and the nominal exchange rate, the positive covariance of thesevariables, and abrupt swings in real sector expectations (see Figures 1 and 2).This volatility largely stemmed from changes in market perception of thepublic sector debt outlook, which depended heavily on the availability or lackthereof of some external support.7 To the extent that such fluctuations wouldaffect the future path of inflation and growth, they presented seriouschallenges for monetary policy under a framework that was at its infancystage. Additionally, there were concerns regarding the sustainability of fiscaldiscipline, as the turnaround in the primary surplus was largely due to low-

6 The gross debt ratio increased from 63% at end-2000 to 101% by end-2001, as the share of

floating rate notes and foreign exchange denominated and linked debt in total domestic bonds

reached 75%.7 During the first half of 2002, the IMF programme was on hold and at the same time the US had

offered Turkey a financial package that could have provided in excess of US$30 billion in return for

passing a parliamentary motion allowing US troops’ entry to Iraq through Turkey. The rejection of

the motion came as a big surprise and caused extreme volatility in the Turkish markets.

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quality measures and sustainability depended on completion of reforms inchallenging areas.8

Nevertheless, the fiscal conditions gradually improved and became moresupportive to monetary policy, as the government performed well on theprimary surplus. The debt ratio declined significantly (by 32 percentagepoints by end-2005), the instrument composition of domestic debt and its

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Figure 2: Business expectations and exchange rate

8 Sharp increases in the primary surplus were achieved by increases in indirect taxation and

cutting investments in the past during difficult economic times. Yet, fiscal discipline unraveled

shortly after conditions stabilised, as challenging reforms regarding taxes and social security were

never completed, which were also a part of the ongoing IMF programme at the time IIT was

introduced. It was important for the CBT to be able to disentangle temporary from permanent

influences on the budget balance in order to gauge the medium-term orientation of fiscal policy.

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maturity improved and the movements in the exchange rate and bond yieldsdecoupled as volatility in markets declined substantially.

The banking sector was weak at the start of IIT and its vulnerabilityimproved gradually. Depreciation of the Turkish Lira, high funding costs andeconomic contraction eroded the capital base of banks, as non-performingloans mounted. In May 2001, the Banking Sector Regulatory Agency (BRSA)announced a rehabilitation programme and with immediate action publicsector banks were re-capitalised, as their accumulated hidden losses wererecognised. Among other obvious benefits for banking and the policyenvironment in general, this was an important step that provided immediatesupport to the CBT’s monetary policy, as public sector banks were heavy netborrowers in the overnight market, which put upward pressure on interestrates. Yet, restructuring of the private banking sector was a gradual processthat spread over several months, as recapitalisation was largely left tovoluntary capital injection by owners or through mergers carried out by theState Deposit Insurance Fund.9 The supervisory BRSA role was improved inseveral ways, which improved risk management and helped to reduce overallrisks in the banking sector.10 Thus, whereas the weakened banking systemmay have been a challenge for the IIT framework in its early stages, theoverall improvement in the sector, particularly the progress in balance sheetrisks, gradually eased the concerns of the CBT.11 The arrival of foreign bankswas also a positive development for the banking sector, as between 2002 andmid-2005, foreign ownership of bank shares increased from 3.1% of the totalto 12.3%.12

Putting all this together, during 2002–2005 the economic environmentseemed to have improved progressively for better support of the IITframework. The improvement in fiscal dominance and provision of officialfunding together with the higher credibility achieved through outperformingof inflation targets laid the groundwork for an effective monetary policyframework going forward.

9 The costs of recapitalising public sector and private sector banks were approximately 15% of

GDP for each, as the total reached 35%.10 Major improvements included the incorporation of market risks in capital adequacy

calculations, imposing strict limits on newly defined related-party lendings, setting of new rules and

supervisiory practices to limit/control foreign exchange exposure, implementation of new

provisioning rules and limits on non-financial participations.11 Short foreign exchange positions of the banking sector declined significantly from US$15

billion in 2000 to US$0.6 billion in 2002.12 Major takeovers/mergers involved big European names such as Unicredito of Italy (50% of

Koc Financial Services), Fortis of Belgium (100% of Disbank), BNP paribas of France (50% of

Turkiye Ekonomi Bankasi) and Rabobank of Netherlands (36.5% of Seker Bank) as well as USA-

based GE Consumer finance (26% of Garanti Bank).

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At the start of 2006 these positive developments led to the announcementof the full-fledged IT providing further transparency to the monetary policyframework and change in IMF conditionality adding more flexibility tomonetary policy.� The role of the MPC changed from being an ‘advisor to the Governor’ to

‘decision maker’. The targeted index remained as headline CPI and a 72%

tolerance band around the inflation path leading to the central target was

established.13 The CBTannounced that monetary policy would accommodate

the first round effects of inflationary supply shocks (oil price increases,

changes in indirect tax rates, etc.) to the extent that forecast inflation remains

within the tolerance margin and will react to these shocks only if they lead to

second-round effects through deteriorating inflation expectations. Positive

shocks to inflation were to be treated in the same manner such that the CBT

will react opportunistically and may allow inflation to decline to the bottom

of the band while not easing monetary policy.

� Under IIT, the IMF programme conditionality in the monetary area relied on

two performance criteria: a ceiling on CBT’s NDAs and a floor on its NIR.14

With full-fledged IT, the NDA target was eliminated.15 The additional

flexibility introduced to the monetary framework through the elimination of

NDA performance criteria and base money indicative targets was a significant

change to the regime. Given the reverse currency substitution that took place

in Turkey during 2002–2005, inflation and base money growth rates

decoupled since mid-2003. Thus, while keeping a close eye on developments

in monetary aggregates was still important, the increased flexibility to the

regime improved the CBT’s ability to follow an information inclusive strategy

in which many variables could be used for the setting of its overnight interest

rate policy tool.16

13 Inflation targets for year-end 2006, 2007 and 2008 were set at 5%, 4% and 4%, respectively,

with the year-end target for 2009 also kept at 4%.14 In this type of set up, the main role of the NIR floor is to indicate whether the programme is

likely to achieve its external objective, while the ceiling on NDA seeks to ensure that this objective is

not jeopardised by excessive credit expansion and sterilised intervention (Blejer et al., 2001).15 This change seems to have led to the need to adapt different monetary conditionality to take

into account the specific features of the full-fledged IT framework. Accordingly, an inner and an

outer tolerance band is established around the central target path for conditionality purposes. The

former is 1% and if it is breached (at quarter-end or year-end), this will require an informal

consultation with the IMF on policy response. The outer band is 2% around the central path and if it

is breached there will be a formal review of policies by the IMF Board.16 The IT regime has an advantage such that a stable relationship between money and inflation

is not critical to its success. The strategy does not depend on such a relationship, but instead uses all

available information to determine the best settings for the instruments of monetary policy.

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� The changes in 2006 increased the CBT’s accountability as well. The CBT

began to issue inflation forecasts and in the event of a difference between the

inflation outcome and the target, the CBT was obliged to publish a report

explaining the underlying causes to the public. Should the CBT project a

difference for the period ahead, it would also submit a report to the

government explaining the reasons for this variance including a set of

measures to be taken to bring inflation back in line with the target path.

OPEN ECONOMY IT REGIME: REVIEW OF SOME POLICY ISSUES FOREMERGING MARKETS

As demonstrated in Eichengreen (2002), IT monetary rules are generallyderived from the following representation of the economy:

J tþ1 ¼ J t þ aðyt � y�Þ þ etþ1 ð1Þ

ytþ1 � y� ¼ lðyt � y�Þ � bðrt � r�Þ þ Ztþ1 ð2Þ

Equation 1 is an accelerationist Phillips Curve, where next period’sinflation (J ) is determined by this period’s gap between actual output (yt)and potential output (y*), the current inflation level and a disturbance term(et+1). Equation 2 is an aggregate demand function where next period’soutput gap is determined by the deviation of the real interest rate (rt) from itsnormal level (r*) in the current period, current period’s output gap and adisturbance term (Zt+1).

The key feature of this closed economy representation is that policy ratechanges effect inflation through the aggregate demand channel only, whichoccurs with a lag of two periods. The monetary policy implication of this isthat optimal policy under strict inflation targeting calls for setting the inflationtarget (J*) two periods ahead, as next period’s inflation cannot beinfluenced by policy rate changes in the current period. Given theseassumptions, the optimal central bank reaction function leads to thefollowing well-known Taylor rule, which assigns positive weights ondeviations of inflation from target and output from its potential level:

rt ¼ r� þ jðJ �J Þ þ wðyt � y�Þ ð3Þ

where j and w depend on parameters of equations 1 and 2.17 The parameter

17 Note that j¼ 1/(ab) and w¼ (1+l)/b.

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values of the inflation gap and output gap variables would then indicate thedegree of flexibility in the IT regime in this closed economy.18

Adding the foreign trade component of the economy to the aboverepresentation yields the following open economy equations:

J tþ1 ¼ J t þ aðyt � y�Þ � gðet � et�1Þ þ etþ1 ð4Þ

ytþ1 � y� ¼ lðyt � y�Þ � bðrt � r�Þ � det þ Ztþ1 ð5Þ

where the exchange rate (e) is defined as the foreign price of domesticcurrency.19

The inclusion of open economy attributes introduces three key features tothis model of the economy with significant implications for monetary policy.Firstly, it introduces an additional aggregate demand channel through whichpolicy rate changes may influence. As such, an increase in policy rates willdepress net export demand, and thus aggregate demand and inflation, byappreciating the currency. This indirect aggregate demand channel workswith a two-period lag as in the closed economy aggregate demand channel.Secondly, this additional aggregate demand channel in the open economyframework increases the response of inflation to policy rate changes. Thepolicy rate adjustment required to close a given inflation gap is smaller themore responsive is the aggregate demand to interest rate changes and themore responsive is the inflation rate to changes in aggregate demand.20

Thirdly, a direct exchange rate effect on inflation, which takes one period, willoccur through a decline in inflation of imported goods as the currencystrengthens. Importantly, the emergence of this direct exchange rate channelgives the central bank the ability to influence next period’s inflation rate,hence allowing inflation to converge to its target path faster in the event of aninflation gap.

Under the open economy framework, the question of whether ITcountries should explicitly consider the exchange rate as a variable in theirmonetary rule given the existence of these open economy channels is a

18 A value of zero to w would correspond to a strict IT regime.19 The starting point of the derivation of open economy equations is the interest parity

condition: et¼ E(et+1)¼ rt�r0+Vt, where E is an expectations operator and r0 and Vt are foreign

interest rate and pure portfolio disturbances (Eichengreen, 2002).20 Likewise the adjustment in the policy rate to a given output gap would be smaller, the more

sensitive aggregate demand is to interest rate changes and the weaker is the level of persistence in

output.

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somewhat unresolved issue. Particularly, how should an ITcentral bank reactto shocks that cause a sharp weakening in the exchange rate? For examplehow policy rates should be adjusted in response to a sudden reversal ofcapital inflows resulting from external factors, which weakens the exchangerate temporarily? This transitory shock may require an increase in the policyrate to dampen future demand-induced inflation, yet the increase shouldtarget to dampen only the domestic component of inflation not the importedcomponent, which is temporary (Eichengreen, 2002). Likewise Ball (1999)argues that responding to the domestic component of inflation producesbetter results when shocks to the exchange rate are temporary. The logic isthat responding to a problem in the current period that will have disappearedthe next period, using an instrument that takes one period to work, willincrease inflation and output volatility. Note that this assertion is a directresult of the existence of policy lags such that responding robustly to atemporary shock destabilises the target variables. If the weakening in theexchange rate is the result of a real shock to the foreign component of aggre-gate demand (to terms of trade or export demand), weaker aggregate demandwill be deflationary in the intermediate term. While the correction in theexchange rate will be inflationary, the appropriate response under the IT frame-work is to allow the exchange rate to adjust and refrain from increasing theinterest rate when the economy is weakening (Mishkin, 2000). Eichengreen(2002) on the other hand argues that the central bank may still raise policyrates that will limit depreciation in the short run, while still allowing theexchange rate to adjust eventually to its new long-run equilibrium.

Responding to exchange rate shocks become more complicated forcentral banks in emerging markets where exchange rate pass-through toinflation is high and liability dollarisation is widespread. Figures 3–5 showthe experience of Turkey (see the fifth section for a detailed analysis). In mostemerging market economies, given lack of credibility of economic policiesand history of high and volatile inflation, economic agent’s often fear thattransitory shocks to the exchange rate will be accommodated by monetarypolicy. Thus, with faster exchange rate pass-through the temporary rise ininflation may become permanent. In the framework presented above highpass-through implies that a change in the exchange rate has a larger short-runnegative impact on inflation (larger g in equation 4) and a smaller short-runpositive impact on output (smaller d in equation 5) since nominaldepreciations have a weaker impact on the real exchange rate. Theimplication of this is that it creates a big temptation for the central bank totighten monetary policy when facing a temporary weakening in the exchangerate (Eichengreen (2002). Because if the central bank tightens monetarypolicy in response to a weakening in the exchange rate, there is more to gain

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from disinflation and less to lose in terms of output due to loss ofcompetitiveness. Cabellero and Krishnamurthy (2003) argue that becausethe principal constraint on output growth in emerging market economies is ashortage of external funding, raising interest rates reduces exchange ratedepreciation and hence limits inflation, with limited effects on output beyondthe impact of the external constraint.

The existence of currency mismatches in emerging markets leavesbalance sheets of the private and public sectors vulnerable to exchange ratedepreciation. As such, an increase in the exchange rate decreases net worth of

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the private sector, which is followed by a decline in private sector demandand hence output (Cespedes et al., 2000). Moreover, as the exchange ratedepreciation increases the public sector debt ratio in the existence of publicsector foreign debt, fiscal policy response in the form of lower expenditureand/or higher taxation also decreases aggregate demand and output. Thebalance sheet effects also imply a reduction in the value of d in equation 5, theconventional positive response of output to currency depreciation.21

The key issue then is that when the exchange rate weakens in emergingmarket economies, the coexistence of high pass-through and liabilitydollarisation means that there will be a sharp rise in inflation in the shortrun but also a strong disinflationary effect in the longer run, that is, postexchange rate pass-through, as indicated by Eichengreen (2002) and Gomez(2004). Carranza et al. (2004) show that inflation may respond negatively tonominal depreciations with this effect being more intense the higher the levelof dollarisation of the economy and during the recessionary part of thebusiness cycle. Therefore, in the event of nominal depreciation, an IT central

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Cumulative Exchange Rate Pass-through to Tradable CPI 1996-2007Cumulative Exchange Rate Pass-through to Tradable CPI 2002-2007

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Figure 5: Exchange rate pass-through

21 Eichengreen (2002) also argues that liability dollarisation may lead to an extreme case where

balance sheet effects are so large that d turns (�) and �d>b. When the exchange rate depreciates by

a large amount the balance sheet effects may dominate, but when it depreciates by a small amount

the favorable competitiveness effects may dominate. In other words, for a range of depreciations, the

weakening in the domestic currency may have an expansionary affect on output whereas

depreciations above a threshold may lead to contraction in output. The latter case occurs when the

sharp depreciation does little to enhance competitiveness because of the speed with which it is

passed through to inflation. So if the exchange rate weakens sufficiently the CB will react strongly to

bring back the currency and avoid severe balance sheet effects on banks and non-banks. If the

depreciation is mild then the response will be mild as well where the CB will allow the exchange rate

to adjust to a new long-run equilibrium.

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bank should feel less compelled to raise interest rates in order to strengthenthe domestic currency and limit the short-term rise in overall inflation due torising import prices.

Cabellero and Krishnamurthy (2003) argue that the IT central bank willallow the exchange rate to float freely in the face of an external shock; thisdecreases the demand for imported investment, which in turn decreases theinterest rate. Gomez (2004) argues that if central bank monetary policy looksbeyond the short term, the central bank is able to decrease interest rates.Whereas if the central bank raises interest rates to minimise the short-termrise in inflation (dubbed fear of floating by Calvo and Reinhart, 2002),monetary policy reaction combined with strong balance sheet effects is likelyto be procyclical as the demand for imported investment will increase. Thistype of reaction by the central bank may be inconsistent with the long runinflation target.

Gomez (2004) also argues that an IT central bank must emphasise thatinflation will go back to target after the first round effects of the exchange rateshock. Emphasis on the medium term and the central bank commitment tothe long-term target could be the primary elements of the communicationstrategy under the IT framework. Mishkin (2004) also proposes that under asharp depreciation, the central bank should focus on inflation after the shock.While depreciation causes inflation in the very short term, monetary policytransmission mechanisms, especially the aggregate demand channel, takeabout 2 years to effect inflation sizably. In the face of an unanticipated eventsuch as a sudden stop, the central bank is unable to attain the inflation targetin the short term.22

On the other hand, Ball and Reyes (2004, 2006), Eichengreen (2002)and Mishkin (2004) also argue that with the IT approach to monetarypolicy; movements in the exchange rate will be taken into account indirectlyin setting monetary policy, because the exchange rate affects price beha-viour. This will generally produce a pattern of monetary tightening whenthe exchange rate depreciates, a response similar but not necessarily ofthe same magnitude, to that which would be undertaken if the exchange ratewere being targeted directly. For this reason, an IT country may appear to beshowing fear of floating behaviour.

22 Cabellero and Krishnamurthy (2003) argue that the central bank could target inflation in

non-tradables. The advantage of this is that it prevents the central bank from giving excessive

attention to the exchange rate on inflation in the short-term, and it enables the central bank to pay

due attention to inflation in the medium term and countercyclical monetary policy. Another policy

option is to introduce escape clauses to the IT framework allowing for the target to be amended in

the face of shocks to the exchange rate.

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Four main points emerge from these papers. Firstly, in the event of ashock to the exchange rate, the most permanent and thus important effect ofmonetary policy on inflation and output depends on the central bank’sreaction. Secondly, in emerging market economies where exchange rate pass-through is high and liability dollarisation is widespread, the central bankshould focus on the domestic component of inflation with the aim ofreturning inflation to the target path in the longer term when the exchangerate weakens. Thirdly, fear of floating type of reaction by the central bank toan exchange rate shock controls exchange rate pass-through during the firstyear, but at a cost: a protracted recession in the longer horizon. Finally, thereis a fine line between domestic interest rate increases that are associated withexchange rate fluctuations but are due to strict adherence to an openeconomy IT regime and changes due to fear of floating which imply a hiddenpolicy goal of managing the exchange rate. The problem addressed here isone of measurement.

From a policy perspective, it is also important to note that neither highexchange rate pass-through nor liability dollarisation is exogenous. Exchangerate pass-through is estimated to be higher in emerging market economies.23

Yet it is also true that adoption of IT has led to lower pass-through in severalemerging market economies.24 Several factors are known to affect themagnitude and speed of pass-through from exchange rate changes toinflation. Among others, the output gap, the type of exchange rate regimein place, the perceived degree of policymakers’ commitment to disinflation,trade openness, and the level and volatility of inflation influence thedynamics of the process. The output gap affects the pass-through by reducingthe firm’s power to increase prices, as during times of increasing sales firmsfind it easier to pass-through increases in costs to final prices (Goldfajn andWerleng (2000).The inflation level affects the persistence of cost changes,which is positively correlated with pass-through (Taylor, 1993). This view, asexpressed by Campa and Goldberg (2002) is that the pass-through of costsinto mark-ups is endogenous to a country’s inflation performance, generatinga virtuous circle where low inflation variability leads to reduced mark ups,less inflationary implications of monetary expansions and continued lowmark ups. Credible monetary authorities are expected to act according to theinflation stability objective, which keeps low inflation expectations even inthe advent of a large depreciation. Put differently, enhanced credibility of themonetary framework will tame the worries regarding the prospect that

23 See Borensztein and De Gregorio (1999), Goldfajn and Werleng (2000), Schmidt-Hebbel and

Tapia (2002).24 See for example Nogueira (2006) and Choudhri and Hakura (2006).

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transitory exchange rate shocks will be validated and hence becomepermanent. Output effects of liability dollarisation (currency mismatches)are also not completely independent of the type of monetary regime. As sucha flexible exchange rate will encourage hedging by banks and non-banks anddiscourage currency mismatches. Flexibility in the exchange rate endogenisesliability dollarisation and currency mismatches can be reduced to some extentwith flexibility and other prudent policies (Goldstein and Turner, 2004).Cabellero and Krishnamurthy (2003) show that fear of floating may seemoptimal from a contemporaneous perspective, as it dampens short-terminflation with limited output effects, and yet it is suboptimal ex ante. Thereason for this suboptimality is that the anticipation of the central bank’s tightmonetary policy during the sudden stop has important effects on the privatesector’s incentives to insure against sudden-stop events. Simply put,contracting dollar debt is less costly in an environment where the domesticcurrency is expected to be supported in the event of a sudden reversal ofcapital inflows. Thus, the anticipation of tight monetary policy leaves theeconomy less insured against the sudden stop.25

PATH OF POLICY RATES IN TURKEY DURING 2002–2007: TAYLOR RULEESTIMATIONS

Four factors in particular seemed to have influenced interest rate policy in theenvironment of floating exchange rates and IIT. First, the vulnerability ofpublic sector debt required excellent coordination among fiscal policy, publicsector debt management and interest rate policy. When markets areconcerned about the sustainability of public sector debt, as they wereincreasingly in Turkey in the aftermath of the 2001 crisis, policy rate changescan have a powerful unconventional impact on expectations. As such, if ratesare increased or cuts are delayed, the markets tend to expect futuremonetisation of debt in which case tighter monetary policy could worseninflation expectations and lead to higher inflation. Fiscal dominance becamelesser of an issue with declining debt ratio, extending maturity and strictadherence to large primary surpluses. Secondly and closely related to thefiscal issue, the perception of risks regarding the adherence to the IMFprogramme targets and the implementation of structural reforms at timesheavily dominated market expectations, particularly in the early stages andseemed to be a key variable affecting policy rate decisions.26 Thirdly, there

25 They model the sudden stop as a tightening of international financial constraints.26 There were significant delays in completion of IMF programme reviews during 2002–2006.

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were ambiguities regarding the transmission mechanism from interest rates toeconomic activity and inflation, as indicated by the CBTon several occasions.The effectiveness of the impact of interest rate changes on inflation throughthe aggregate demand channel was questionable given the relatively low levelof financial intermediation. Moreover, the existence of a relatively stable andpredictable link between the output gap and inflation was in question as well.Finally, the real exchange rate appreciated strongly (by 38% during 2002–2005), which was due to strong capital inflows and partial de-dollarisation.This complicated the gauging of monetary conditions, as the exchange ratechannel of monetary transmission was conjectured to be strong and quick inTurkey. The questions of how much real appreciation the CBT should haveallowed and how monetary policy should react to occasional sharpcorrections in the exchange rate became important issues shortly after theintroduction of IIT.

The CBT’s successive rate cuts brought the overnight policy interestrate from 59% to 13.75% during January 2002–April 2006. In the mean-time, inflation decreased from 70% to 7.08% by mid-2004 before climbingup to 8.18% in April 2006. In due course, year-end CPI point inflationtargets of 35%, 20%, 12% and 8% for 2002, 2003, 2004 and 2005,respectively, were outperformed (see Figure 6). Yet, the 4% target for end-2006 was missed by a wide margin as inflation increased to 9.67% on theback of a temporary weakening in the exchange rate in mid-2006. In reactionto the sudden stop that occurred in May–June 2006, the CBT raised its policyrate to 17.50%.

Eyeballing the data for the entire IT period seems to suggest that the paceof CBT’s nominal policy rate changes more or less reflected the pace ofdecline in inflation expectations, as rate cuts appeared to be more aggressiveat times of sharper decline in the credibility gap (inflation expectations lesstarget path) and more passive (smaller cuts or occasional pause) during slowor no convergence of inflation expectations (see Figure 7). The IIT periodshows that real rates (forward looking) have remained stationary around aprogressively declining plateau (see Figure 8). Real rates were at around20%–22% until mid-2003, thereafter declining to an average 14% till end-2004 and then to an average slightly below 10% till end-2005 before climbingup to around 12% in the second half of 2006. Yet, a more formal analysis ofinterest rate policy with the estimation of an open economy Taylor ruleprovides a simple and easily understood starting point for the analysis ofmonetary policy during the IT period.

We specify a Taylor rule for the real interest rate (r), dependent on thedeviation of expected inflation from the inflation target path (J�J*), theoutput gap (y�y*), the nominal exchange rate depreciation (e) and Turkey’s

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sovereign debt risk premium (EMBITR).27 The latter is added as a proxy ofTurkey’s risk premium.

rt ¼c1 þ c2ðJ �J Þ þ c3ðy� y�Þ þ c4eþ c5EMBITR

þ errortermð6Þ

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Figure 6: Realized inflation and targets

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Figure 7: Policy rate and inflation gap

27 Real rates are obtained by deflating nominal overnight policy rates by 12-month forward-

looking inflation expectations based on CBT’s survey among private sector economists. Monthly

output gap values were derived from quarterly figures provided by the CBT using a quadratic

matching of the average.

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Our sample period is January 2003–December 2006, which is relativelyshort and therefore the results should be interpreted with some caution.Nevertheless, we believe that the estimations provide statistical facts thathelp to explain the path of policy rates in Turkey during the IT period (seeTable 1). Four points stand out in particular. Firstly, the estimated CBTreaction function tracks the path of policy rates very closely (Figure 9).Secondly, Turkey’s risk premium has been a very significant factordetermining the path of policy rates during the IT period. Thirdly, resultsindicate that nominal exchange rate changes and output gap developmentshave played a relatively minor role in interest rate decisions.28 Finally, thecoefficient of the inflation gap variable is borderline significant.

The significance of the risk premium variable (EMBITR) and the resultsin general indicate the role of declining equilibrium real rates in CBT’s policyfunction. As further improvements towards building a sustainable fiscalregime and stronger banking sector among other reforms were completed,Turkey’s risk premia declined. It seems that during this period of structuraltransformation and transitional dynamics, the CBT was searching for anequilibrium real rate commensurate with low(er) inflation. The morecomfortable the CBT felt with progress on these fronts, the easier andquicker have been the move to lower real rates.

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Figure 8: Overnight rates

28 Although we thank an anonymous referee for pointing out that the fact that the risk premium

could change in response to inflation, output and exchange rate developments, these factors may

have still affected policy rate decisions.

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EXCHANGE RATE PASS-THROUGH, CAPITAL INFLOWS AND MONETARYPOLICY: 2002–2007

Exchange rate pass-through: empirical results

Exchange rate movements and inflation expectations have played animportant role in inflation dynamics in Turkey over the past several years.29

The past studies have shown that exchange rate pass-through to

Table 1: Estimates of the Central Bank reaction function – equation 6

Dependent variable: REALRATE

Method: Least squares

Sample (adjusted): 2003:04, 2007:06

Included observations: 51 after adjustments

Variable Coefficient Std. error t-Statistic Prob.

C 0.03886 0.01187 3.2754 0.002Inflation Gap 0.42715 0.26236 1.6281 0.111Exchange rate Depreciation 0.04403 0.02214 1.9884 0.053Output Gap 0.24680 0.09180 2.6884 0.010Risk Premium (EMBITR) 2.29398 0.38783 5.9150 0.000AR(1) 1.06049 0.15322 6.9215 0.000AR(2) �0.27058 0.14433 �1.8747 0.068

Adjusted R2 0.964445 F-statistic 227.04 0.00

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Figure 9: Taylor rule estimates

29 See Saatcioglu and Korap (2006) for a comprehensive review of the literature on Turkish

inflation.

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inflation in Turkey is relatively quick and high.30 On the other hand, recentstudies indicate that exchange rate pass-through to both non-tradable andtradable components of CPI inflation in the IT and floating exchange rateenvironment has declined (Kara et al., 2004, 2007). In this section, weestimate exchange rate pass-through with more up to date data by looking atthe dynamic relationships between inflation, exchange rate depreciation, andoutput gap. Impulse responses obtained from this multivariate VAR frame-work are then used to calculate exchange rate pass-through. Accordingly thepass-through coefficient is computed as the ratio of cumulative impulseresponses of inflation to the cumulative impulse responses of exchange ratedepreciation to a shock in the latter. The computation is done for several timeintervals to assess the extent and speed of pass-through.31 As well, we look atthe change in the dynamics of exchange rate pass-through to overall CPIinflation and its tradable and non-tradable components during the IT period.

The model is estimated for the period January 1996–June 2007 andincludes interactive dummy variables for all variables in the system, whichtakes the value of zero for the time period prior to the introduction of IIT(January 1996–December 2001) and the value itself of the respective variableduring the IIT period (January 2002–June 2007). This would be a convenientmethod for evaluating changes, if any, in the size and speed of exchange ratepass-through following implementation of the IIT framework. Hence, two setsof impulse responses are considered in calculating pass-through.

Our analysis shows two important findings. Firstly, results indicate thatpass-through reaches 34% for the CPI index in a 12-month period withsome 86% of that taking place in the first 6 months following the exchangerate shock during January 1996–June 2007 (see Figure 3). Secondly, duringthe IT period the speed (marginally) and size of pass-through declines. Assuch, 24% of the exchange rate depreciation is passed on to consumer pricesin 12 months with just below 80% of that being completed in 6 months (seeFigure 3).32 Kara et al. (2007) argue that the decline in pass-through is notsurprising given the changes to the monetary policy framework and theinstitutional developments taken place including the operational indepen-dence of the CBT.

While lower pass-through is a positive development, Edwards (2006)argues that this ‘inflation-centred’ view is too simplistic and it tends to ignore

30 See for example Leigh and Rossi (2002).31 For example pass-through after 12 months corresponds to the ratio of the cumulative impulse

responses of inflation to cumulative impulse responses of depreciation during the 12 periods

following the exchange rate shock. This methodology, based on McCarthy (1999), has been widely

used and was also the approach adopted by the CBT research department.32 Our results are similar to those of the CBT (see Kara and Ogunc, 2004).

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the role of relative prices and the real exchange rate. As such, for theexchange rate to act as a shock absorber in general, changes in the nominalexchange rate must be translated into real exchange rate changes. It is thusimportant to distinguish between two notions of exchange rate pass-through:pass-through into non-tradables and pass-through into tradables. From apolicy perspective, pass-through coefficients for tradables and non-tradablesshould be different, with the former being higher than the latter. It followsthen that the adoption of IT regime would improve the shock absorbingcapacity of nominal exchange rates if the pass-through from exchange rate tonon-tradable prices has declined or if the pass-through to tradable good priceshas increased (or, at least, has not declined) as argued by Edwards (2006).

We used the same methodology to estimate the exchange rate pass-through to the non-tradable and tradable parts of the CPI and the impact ofthe IT regime on the process.33 This analysis showed two important results.Firstly and as expected, the exchange rate pass-through to tradables is muchstronger than that to non-tradables for the entire sample period as well as theIT period. Secondly, there seems to be a significant decline in the speed andextent of pass-through to non-tradable prices while the decline in pass-through to tradable prices seems to be more mild (Figures 4 and 5). While37.1% and 43.1% of the exchange rate depreciation is passed on to non-tradable prices in 6 months and 12 months during the full sample period, therespective figures for the IT period are much lower at 15.2% and 23.4%.34

The improvement in the speed of exchange rate pass-through to tradablesseems more significant than its magnitude. While three-month cumulativepass-through in the IT period declined to 18% from 30%, the correspondingfigures for the 12-month horizon are similar at 42.6% and 46.5%,respectively. While Kara et al. (2007) indicate that the sharp decline inpass-through to non-tradables is a sign of the decline in expectations-drivenpass-through, they attribute its more pronounced improvement relative to thetradable CPI component as an indication of the weakening of indexation-driven pass-through.

In summary, there seems to be strong evidence of a change in thedynamics of the exchange rate pass-through that has enhanced the shock-absorbing ability of floating exchange rate regime. The results presented byothers and those shown here suggest that the pass-through effect should beless of a concern for policymakers in Turkey and provide a rationale for a

33 Since the State Institute of Statistics does not report a tradable and non-tradable breakdown

of the CPI index, we used our own estimates.34 Our findings are similar to those of Kara et al. (2007) in terms of the change in the dynamics

of pass-through for the overall CPI index as well as for its tradable and non-tradable components.

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relatively weaker reaction of monetary policy to sharp exchange ratemovements in the IT period.

‘Sudden Stops’ and monetary policy reaction

Following the switch to the new monetary framework, the CBT repeatedlyemphasised, through regularly published reports as well as through publicappearances by officials, that the exchange rate was not a target for monetarypolicy. Instead, the CBTannounced its intention to smooth excessive volatilityin the nominal exchange rate without altering the trend movement in the realexchange rate.

Rising confidence in Turkey on the back of disinflation and stronggrowth, the start of EU accession talks and favourable global conditionsin general resulted in a surge in capital inflows during the IIT period (seeFigure 10). While foreign investor holdings of Turkish equities and YTLdenominated government bonds increased significantly, inflows from foreigndirect investment increased sharply as well. Equity and government bondholdings of foreign investor’s increased from $3.5 to $42 billion and $3.6to $21.5 billion, respectively, from the beginning of 2002 to April 2006(see Figure 11). While total FDI inflows were $13.5 billion during the previous15 years prior to 2002, the figure from there on to 2007 climbed by another$43 billion. These developments together with de-dollarisation put downwardpressure on the nominal exchange rate. While resident’s foreign exchangedeposits in the banking system stood at over 55% of total bank deposits atend-2002, the figure declined to below 34% by mid-2006.

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Given the strength in capital inflows, from 2002 to mid-2007, the CBT’sreserve accumulation through discretionary purchases and pre-announcedauctions were US$25.2 and US$23.4 billion (net), respectively, as CBTreserves increased from US$19 to over US$65 billion (see Figures 10 and 12).The CBT officials communicated that such discretionary reserve purchasesshould not be seen as a result of CBT’s disapproval of the level of theexchange rate and that buying reserves through auctions mainly reflectedthe intention to build reserves given the heavy official debt repaymentschedule and the desire to improve external risk parameters. Moreover, the

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timing of initiation, suspension and resumption of auctions was said to be apart of CBT’s strategy to curtail excessive volatility through signalling effects.Although the markets did feel on some occasions that the sole purpose of CBTintervention was to prevent the exchange rate from appreciating more than acertain threshold, as pressure in one direction was not perceived as volatility.The CBT partly sterilised the expansion in base money driven by the rise ininternational reserves (Figure 13). Yet, base money growth remained high and,on average, was three times the rate of annual inflation during the IT period,which partly reflected the rise in demand for real YTL balances.

While the pressure on the exchange rate was downward in general, themarkets were subjected to four sudden stop episodes during the IT period,which resulted in sharp corrections in the exchange rate and the financialmarkets in general. The first two of these episodes occurred during the April–May period of 2004 and 2005 during which mild portfolio outflows were seenfollowing a period of sharply rising inflows (Figure 14). The 2004 episode sawthe exchange rate rise by 17.5%; the sovereign debt yields jump by 190 basispoints and benchmark YTL denominated government bond yields increasefrom 22% to 30%. While local yields and sovereign spreads graduallyreturned to their pre-correction levels by end-year, the exchange rate saw avolatile period before entering an appreciation trend in early 2005 andreturning to its pre-correction level roughly a year later than the start of theepisode (Figures 15 and 16). In the meantime, CPI inflation, which hadsteadily declined to 7.87% from over 70% at the start of 2002, increased to9.35% by end-2004 but remained below the 12% target.

During the April–May 2005 correction in markets, the exchange rateincreased by 9%, sovereign spreads jumped by 235 basis points, while local

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yields increased marginally from 16% to 18.3% (see Figure 15). Normal-isation of yields and spreads took about 3 months while the exchange rategained back one-third of its loss against the US dollar within 2 months afterthe initial shock and remained more or less at its new level for the following12 months (see Figure 15). Inflation continued to decline following the April–May 2005 correction in the markets, as it fell from 8.18% in April 2005 to7.72% at year-end.

Casual observance of the data indicates that the CBT did not reactstrongly to the first two externally driven corrections in the IIT period (seeFigure 16). The sudden stop-driven corrections during April–May in 2004 and2005 caused the CBT to halt policy rate cuts, as the credibility gap (inflation

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Sep-0

5

Jan-

06

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-06

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6

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07

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-07

Monthly Portfolio Inflows

Figure 14: Portfolio inflows

12%

17%

22%

27%

32%

Mar-

04Ju

l-04

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05Ju

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06Ju

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Mar-

07Ju

l-07

150

200

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500

Local benchmark at secondary market (lhs) EMBI-Turkey (rhs)

Figure 15: Sovereign debt spreads and local debt yields

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target less expectations) widened. Yet the CBT refrained from intervention inthe foreign exchange market to prevent YTL weakening.

The mid-2006 episode, the strongest of all sudden stops Turkey wassubjected to under the IT framework, resulted in net total portfolio outflows ofabout 4 billion US dollars, equivalent to about half of cumulative inflows duringthe prior 12 months of the shock, which led to a 28% correction in the exchangerate, rise in YTL benchmark yields from 13.7% to 21.3% and sovereign spreadsby 150 basis points. The shock was mainly driven by negative developments inglobal liquidity, yet the strength of deterioration in Turkish markets was relatedto domestic developments as well. The markets seemed to take into accountTurkey’s rising current deficit (from 0.8% in 2002 to over 7.5% by mid-2006)and its sensitivity to increasing oil prices. But more importantly, April inflationfigures released early May came in much higher than market expectations afterthe CBT had lowered its overnight policy rate on April 27 by 25 basis points. Theexternal shock also coincided with a period of prolonged uncertainty regardingthe appointment of the new CBT governor. The government’s first choice, whichwas revealed at the last minute following a period with a caretaker, a vicegovernor at the time, was vetoed by the president. The entire process washandled very poorly and raised doubts regarding the credibility of the monetaryframework shortly after the move to full-fledged IT.

The policy response by the CBT was much stronger this time around, asthe overnight policy rate was increased by 400 basis points in a matter of 3weeks following two emergency MPC meetings on 7 June and 25 June and theCBT sold close to US$2.1 billion in reserves (3.5% of total). Policy rates wereincreased by another 25 basis points during the 20 July scheduled meeting ofthe MPC bringing the total tightening to 425 basis points (see Figure 16). By

12%

14%

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18%

20%

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28%

Jan-04

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-04

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-07

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Overnight Policy Rate (lhs) YTL per $ US (rhs)

Figure 16: Policy rate and exchange rate

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mid-August the exchange rate regained half of the initial weakness beforeentering a decisive appreciation trend, which took the exchange rate to belowits pre-correction level about 12 months later (see Figure 16). Yet, local debtyields remained high, easing marginally and remaining around 19% after 12months while sovereign spreads declined to pre-correction levels graduallyafter 12 months (see Figure 15). Inflation increased from 8.16% in May to9.67%, more than twice the 4% target set for end-2006. There were nodiscussions of amending the 2006 target following the mid-year external shockand the CBT argued through its official publications that they expectedinflation to come close to its 2007 year-end target of 4% following thetightening of monetary policy. Their official forecast saw inflation fallingbetween 9.1% and 10.5% by the end of 2006 with a 70% probability in theirthird-quarter inflation report issued on September 2006, which did not provideforecasts for end-2007. The first report of 2007 issued in March provided aforecast for end-2007 between 3.6% and 6.6% with a probability of 70%.

The repercussions of a sudden stop of the magnitude, seen in May–June2006, can be widespread for Turkey. The two immediate effects of theexchange rate correction are the short-term rise in inflation given exchangerate pass-through and slowdown in demand mainly as a result of the affect ofdepreciation on balance sheets given widespread liability dollarisation. Yet, asdiscussed in the third section, both where the economy settles in the longer-term and the permanent effect of capital outflows would be heavilyinfluenced by monetary policy reaction. With respect to the latter, for theTurkish case particularly, six issues could have been taken into consideration.Firstly, while still high, the post-IT developments in exchange rate pass-through were encouraging and particularly, the sharp decline in pass-throughto the non-tradable component of the targeted CPI index should haveprovided some comfort to policymakers in terms of the medium-term path ininflation following the external shock. Secondly, the weakening in theexchange rate would likely to generate forces to decrease inflation overthe medium-term through balance sheet effects on economic activity. Thetrue extent of the currency mismatches and the balance sheet effects canbe difficult to measure.35 Given the sharp decline in currency mismatches inthe banking sector (from $14.5 billion at end-2001 to $0.6 billion at mid-2006), the decline in foreign exchange denominated net public sector debt(from $88bn at end-2002 to $30bn at mid-2006), and evidence provided onthe foreign currency position of the corporations and households, the

35 The proper measurement, the aggregate effective currency mismatch, as defined by and

presented in Goldstein and Turner (2004), shows that mismatches have peaked in Turkey in 2002

(page 50).

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aggregate currency mismatches seem to have improved since 2002. Weconjecture that aggregate mismatches remained at levels that would unlikelyto cause systemic financial distress but that weakening in the currency woulddecrease economic activity through the same dynamics seen over the pastseveral years. The historical relationship between the real exchange rate andeconomic growth indicates that appreciation periods and acceleration ineconomic activity go hand in hand. Likewise, sharp slowdowns in growth areassociated with periods of sharp depreciation. Given that the principalconstraint to economic growth has been the availability of external financing,it is not surprising to see that the parallel movements in the exchange rate andgrowth are largely due to fluctuations in capital inflows. Capital inflows leadto exchange rate appreciation, positive balance sheet effects and highereconomic growth. Moreover, appreciation has a positive impact on economicactivity through lowering production costs of firms where imported inputs area large part of the production process and related costs constitute a largeshare of production costs. Likewise, it is through these mechanisms thatexchange rate depreciation causes a decline in economic activity, contrary tothe conventional wisdom. Indeed, Kara et al. (2007) empirically demonstratethese effects in Turkey. As such, they conclude that the cost channel of theexchange rate on output gap dominates the demand channel. Akyurek andKutan (2006) also find that real exchange rate changes lead to changes in theoutput gap in the same direction. Thus, while the sudden-stop-drivenexchange rate depreciation would increase short-term inflation mainlythrough the spike in inflation in the tradable component of CPI, its effectson the output gap would be supportive of disinflation in the medium term.Thirdly, adherence to a floating exchange rate, as emphasised repeatedly by theCBT officials on numerous occasions, would be important in terms ofdiscouraging the expansion of widespread currency mismatches and encoura-ging wider use of hedging products. Fifthly, the policy response should, to someextent, reflect the awareness of risks associated with carry trade-drivenexcessive short-term capital inflows and the resulting liquidity expansion.Simply put, large interest rate differentials have been a source of conflict withthe IT regime. Finally, given that the 2006 year-end target became simplyunattainable in the aftermath of the mid-year external shock, the logical moveby the CBT and the government should have been to revise the year-end target.Moreover, given the length of time it takes for the monetary policy transmissionmechanisms to effect inflation, especially the aggregate demand channel, arevision of the 2007 inflation target should have been considered as well.Akyurek and Kutan (2006) and Kara et al. (2007) argue that the impact of policyrate changes on economic activity and inflation have become more predictableand in the direction in line with theory, improving the transmission capacity of

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monetary policy following the change in the monetary regime to IT. Upwardrevision of the 2007 target would have amounted to softening the targeteddisinflation trajectory since the year-end target for 2008 was set at 4% as well.The CPI inflation climbed from 8.83% in April 2006 to over 11% within 4months before declining to the 7.3% level as of August 2006. The return ofinflation to pre-shock levels was a welcome development. And yet, despite thesignificant tightening of monetary policy, inflation was still significantly abovethe path leading to the 4% target. As well and as expected, the deceleration ingrowth became visible only in the second quarter of 2007, that is during thethird quarter following the external shock. These developments are supportiveof the argument for the softening of the targeted disinflation trajectory followingthe external shock of mid-2006.

These complications highlight the view that monetary policy in the realworld is more of an art than a science and there is very little doubt thatengineering an optimal monetary policy response was a challenging taskunder the circumstances following the May–June 2006 sudden stop episode.Yet, increasing interest rates at the speed and extent they were is a policyresponse that should be analysed carefully to the extent that the move seemedto aim at limiting the short-term temporary spike in inflation and containingnegative balance sheet effects through supporting a recovery in the exchangerate. The issue addressed here is one of magnitude. Was the policy responseassociated with adherence to an open economy IT regime or due to fear offloating type of reaction which imply a hidden policy goal of managing theexchange rate?36 While the extent and scope of monetary policy reaction inmid-2006 may suggest a defense of the currency during this episode,particularly when compared to the other three episodes experienced duringthe sample period, we have not attempted to test statistically as to whetherthe CBT has reacted to exchange rate corrections above and beyond theireffects on inflation. To test this possibility the dynamic evolution of the policyfunction must be analysed and at this stage given the shortness of the dataperiod and the ongoing structural transformation in the economy, meaningfulstatistical analysis is difficult to conduct.

CONCLUSION

Turkey’s adoption of an IT-like regime in 2002 occurred when inflation was onthe rise and after banking sector recapitalisation process had led to a

36 Schmidt-Hebbel and Werner (2002) show that countries may exhibit a temporary fear of

floating during particular periods or events.

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significant jump in public sector debt. Concerns over public sector debtrollover were dominating the dynamics of financial markets withstrong repercussions on macroeconomic fundamentals. Fiscal discipline,the improvement in the policy environment and the overall progress in theeconomy provided progressively stronger support to the enhancement of thenew monetary regime, which lent support to the CBT’s decision of a gradualshift to full-fledged ITafter 3 years. The change provided further transparencyto the monetary policy framework and added more flexibility to monetarypolicy.

Evidence from the estimation of a Taylor-like central bank reactionfunction shows that the CBT lowered real rates mainly in conjunctionwith the decline in Turkey’s risk premium, as inflation declined signi-ficantly during 2002–2006. While changes in the exchange rate, outputgap and inflation expectations were found to influence policy rate changes,during this period of structural transformation and transitional dynamics, itseems that the more comfortable the CBT felt with progress on fiscalpolicy and reforms, the easier and quicker seemed to be the move to lowerreal rates.

With the introduction of a comprehensive economic programme,implementation of structural reforms, completion of large privatisationprojects and the start of accession talks with the EU, Turkey attractedsignificant amount of foreign capital. As a result of this, during the inflationtargeting and floating exchange rate period, the YTL remained strong and thereal exchange rate appreciated significantly. The latter together with highgrowth led to a significant widening of the current account deficit, whichrendered Turkish financial markets susceptible to external shocks. Themarkets were subjected to externally driven reversal of capital inflows onthree occasions. While monetary responses to the shocks in April–May of2004 and 2005 were relatively limited, a much stronger reaction was given tothe greater turbulence of mid-2006. The policy reaction of mid-2006 bringsthe question of whether or not this response was associated with adherenceto an open economy IT regime or due to fear of floating type of reactiongeared towards bringing a recovery in the exchange rate. Given the extent oftightening in the policy rate, this question is particularly relevant in theTurkish case where the exchange rate depreciations have been associatedwith economic slowdowns.

Inflation returned to its pre-shock level within a year, yet after havingovershot the 2006 target, it remained significantly above the 2007 target aswell despite the sharp rise in policy rates. The developments in the inflationrate are supportive of the argument for the softening of the targeteddisinflation trajectory following the external shock of mid-2006.

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