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.

GDP Growth and Potential Output in Turkey

It is strange to see that economists taking part in analyzing Turkey do not have a consensus about the third quarter growth projections. Turkey reported a year-over-year growth rate of 2.1% in the second quarter in which exports as a positive contributor to the growth surprised to the upside while investment significantly remained weaker. On quarterly basis Turkey  grew by 5% after reporting a contraction of 6.2% in the first quarter of the year. The bullish side thinks that developments in the foreign trade side will continue to help the country grow its economy. On the other side, doomsayers suggest many macroeconomic indicators like business confidence, industrial output drawing a grey picture. But the both side agreeing the economy will perform poorly compared the past years makes the whole debate a vicious circle.

For the last consecutive fourteen years, the third quarters have been where we have observed booms in consumption, and provided that the consumption is most significant component of Turkey’s GDP, we likely to see a higher GDP growth figure coming out but in any case it will not be able to attract emerging market investors typically seeking for a high growth.

Here below is the numbers posted til date, including the changes observed in components’ growth on yearly and quarterly basis and here is the excel file).

Turkey Economic Performance

But here is the chart where you really can not see anywhere.

Turkey Output Gap

The chart above is visualizing the estimated output gap of Turkey by using the Hodrick-Prescott filter with lambdas of 1600, 98 and 19. According to a paper published by Turkish Central Bank economists the last two lambda numbers are the most effective ones to use for estimating the output gap for Turkey while 1600 is the most commonly used number for filtering the actual GDP numbers from its real trend in the world of economics. The fundamental point of my argument here is that Turkey has been experiencing a negative output gap which is known for its deflationary pressure. And this is where the critical question emerges: As we see a better GDP growth that would probably generate a positive output gap, what is the Turkish Central Bank is planning for stemming inflation? Lowering rates with a “hawkish” stance or doing nothing?

Capacity Utilization Drops in November

Capacity utilization rate (CUR) was realized at 75.6% in November. It means an increase 160 basis points compared to last year but a slight decline month over month by 80 basis points. Seasonally adjusted CUR also dropped to 74.9% by 90 basis points.

Looking at the figures from a broader perspective, the CUR had hanged around 80% in the pre-crisis period of 2008, then following the collapse of Lehman, it dramatically plummeted to 60% as a result of the global recession. Despite the worthy of note improvements, it is still lower than pre-crisis period but also this suggests that Turkey can increase production without causing a rapid upside change in inflation.

Turkey - Capacity Utilization Rate

Business confidence stayed above 100 but demonstrated a slight decline in November. Even if the volume of output supportively remains the same, the significant fall in export orders had been the key factor. Ahead of elections, I clearly do not see macro sign to boost the investment.

Beside of decreasing export orders, the trend line in stocks in process does not seem pretty. We have an upward move in November data but the stable outlook is sign of the weakness of consumption. However, by this, a limited weakness in inflation is expected in the next months depending upon the output gap.

Turkey - Real Sector Confidence Index

Turkey - Stock in Process