Taylor Rule in Turkey

Has the Turkey’s monetary policy been sufficiently tight? This question becomes extremely crucial especially after the Turkish politicians’ blistering attack on the central bank that have raised the concerns about the independence of Turkish central bank. Amid these concerns Turkey central bank has cut the rates twice in 2015 bringing its policy rate from 8.75% down to 7.50%.

Taking back to the question asked at the prelude, the Taylor-rule framework can be used to assess the appropriateness of the monetary policy stance of Turkish Central Bank. Therefore we would be able to evaluate how the central bank responses to inflation and output gap. We can also judge the actual rates by using Taylor rules as a benchmark rate. Despite the fact that these exercises are near impossible to do given frequent structural breaks in the way monetary policy has been conducted resulting in the absence of consensus of what the appropriate coefficients would be for a Taylor rule in Turkey, I’d like to keep on with the most commonly known Taylor rule which implies a response of 0.5 both inflation and output gaps and a real interest rate target of 2%.

I also intend to widen the scope of the work by projecting the Taylor rule to the end of 2016 with using the country-specific economic forecast of OECD as an input who estimates Turkish economy to grow by 3.0%, 3.2%, and 4.0% in 2014. 2015 and 2016, respectively, and the headline inflation rates to be standing at 9%, 7.4%, and 6%.

Turkey - Inflation and Output Gaps

Turkey - Taylor Rule vs Actual Interest Rates

The first above shows the estimated inflation and output gaps in Turkey while the latter generates some important results for my Taylor-rule based assessment of Turkish monetary policy. Turkish monetary authority appears to be remain eased following the global financial crisis. Thus, our question becomes answered. Additionally, within the macroeconomic prospects Turkey may not have to deliver massive rate hikes as a response to the United Federal Reserve’s tightening. However, inflation shocks arising out of fast local currency depreciation and rising food prices and volatility in money markets remain as a key risks to this assumption.

Investment Expenditures by Businesses

In a previous post about Turkey’s GDP growth, we mentioned the investment expenditures of the private sector as the weakest part of the economy. Poor track record in the component has been undermining the growth for a dozen of quarters. Companies allocating less money to extend their businesses also have rising concerns around the sustainability. Because investment expenditures play a central role in macroeconomic activity affecting both short-run business cycles and long-run economic growth. These expenditures reflect the general act of investment involving foregoing current satisfaction to produce capital goods and are officially measured by gross private domestic investment.

The results of the survey of business posted by the Turkish Central Bank yesterday showed the real sector confidence index gaining momentum, hitting a 12-month. However, on the investment side, things still looked gloomy. Despite the rising confidence we saw a monthly drop of 1.6% in investment expenditures in October which was 6% lower compared to its January high.

Investment Expenditures and Business Confidence

Another important point is that the relationship between Turkey’s highly controversial monetary policy and risk appetite of the businesses while making investment decision. As seen from the chart below, Turkish businesses were more proned to invest despite the high funding costs and since then interest rates seem to have had a strong influence on investments. In other words, it is not only higher rates that erode investment confidence of Turkish companies as the investments evidently lost momentum followed by a nosedive in investor confidence.

Turkey - Interest Rates and Business Confidence

One thing Turkish politicians need to clearly understand is that the central bank is not able to provide a permanent solution for the weakness in investment expenditure by businesses.