The Kapali Carsi

The Governor’s Speech: Central Bank of Turkey targets the real exhange rate

Well, not quite…

But speaking to the newly minted Turkish finance portal AA Finans on Monday (videos naturally in Turkish), Central Bank of Turkey Governor Erdem Basci said that if the real effective exchange rate (REER) ends up within the 120-125 range, the Central Bank would ease its monetary policy only gradually, whereas 130 would elicit a strong response, whereby the CBT would utilize all the instruments in its arsenal. Anyway, you can read the details as well as what I feel about this semi-REER target in my latest Hurriyet Daily News column.

Of course, what makes this announcement really interesting is the fact that Basci won’t have to wait for long to support word with deed: The monthly Monetary Policy Committee meeting is on Tuesday. The consensus view before the Governor’s Speech was that the Bank would continue with the last couple of months’ actions- another measured (50bp or so) cut in the ceiling of the interest rate corridor as well as further increases in Reserve Option Coefficients. While these are almost certain, nearly half of the 15 economists surveyed by business channel CNBC-e now expect that the floor of the corridor will be cut as well.

This is not a huge surprise. When investors asked me, during my recent London trip, on how the Central Bank would respond to a surge in capital flows to the country, because of Fitch’s upgrade as well as the country’s attractive position in the hunt for yield, I told them to expect a repeat of the end of 2010, when the Bank lowered the floor and increased the corridor to discourage excessive capital flows.

Nor would I dare to claim that the Governor was bluffing. He was not, although he was naturally trying to talk the lira down- and he succeeded. However, as I will discuss my next HDN column on Monday, I don’t expect a cut in the floor for two reasons: First, Basci already managed to weaken the lira a bit with his verbal intervention on Monday. But even more importantly, there was quite a bit of risk aversion and flight from EM currencies on the back of fiscal cliff worries, bad E.U. data, Japanese politics and so on this week, with equities getting hit much more than bonds. Remember that the Central Bank already made the mistake of loosening in the middle of a storm once- by cutting the policy rate in August 2011, in the middle of the E.U. crisis. The lira paid a heavy price, and the Bank had to administer a very large tightening, albeit in disguise, in October of that year. I don’t think they will make the same mistake again. To put all this into perspective, here’s the trajectory of all the interest rates I am talking about (and more) since September 2010.

Three observations are in order: First, the Central Bank brought the overnight borrowing rate to 1.5 percent back in 2011, while at the same time increasing the lending rate to 9 percent- creating a 7.5 percent corridor. Those rates are 5 and 9.5 percent respectively, so the corridor could go much wider. Second, note how the overnight repo, labelled as “weighted average rate” in the graph, looks like you could surf on it in 2011:) This is the landscape that is awaiting investors should Turkey get excessive capital flows. A third thing to note is that the effective funding rate and the overnight repo, at 5.75 percent and 5 percent respectively, are at their minimum levels. The former is now equal to the one-week repo rate, and the latter to the overnight borrowing rate, which is the floor of the corridor. That’s why the Bank would actually need to cut the one-week repo and/or the floor of the corridor for more easing.

You could argue that fiscal cliff worries are temporary, and the that the Central Bank should not heed this week in its rate decision. I myself was expecting some turmoil in the aftermath of a potential Obama victory & divided Congress when I discussed the economic consequences of the U.S. elections. However, J.P. Morgan has recently argued, according to Bloomberg at least, that the recent sharp fall in 10-year U.S. Treasury yields are indicating bond markets are pricing U.S. falling over the fiscal cliff. If you are buying that, you should agree with me that it would be quite imprudent to cut the floor and widen the corridor at this moment.

But then again, we have a Central Bank that is not afraid of taking risks and has several times even compared to a hedge fund in its actions…

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