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Flexibility in Monetary Policy Hakan Kara Central Bank of the Republic of Turkey Presentation at ICOPEC Conference Kocaeli University September 27, 2012 Outline • Monetary Policy Consensus Before 2008 • How and Why have Policies Shifted Towards More Flexibility? • Implications for Monetary Policy in Turkey • New Policy Framework Designed by the Central Bank of Turkey • Implementation and outcomes 2 Consensus during the ‘great moderation’ • Focusing price stability is the best CBs can do to contribute welfare • Monetary policy is too blunt to react to financial stability • Crisis prevention is costly, so it is better to mop-up afterwards • Financial intermediation costs should be avoided 3 Mindset during the ‘great moderation’ • This time is different! • We know how the economy works • Agents are rational • Therefore, ‘good monetary policy should be boring’ • Predictable,Transparent and Simple 4 Conventional Inflation Targeting Framework • Floating exchange rate regimes • Taylor rule-like reaction functions • • Single objective (inflation) • Single instrument (short term interest rate) New Keynesian models (w/o explicit macro-financial linkages) 5 Was this framework flexible? • At first sight seems so, since under a flexible ER regime the CB can react freely to shocks by adjusting short term interest rates • However, reaction function did not allow much flexibility in practice, because of rule based policy behavior and the scarcity of instruments • Moreover, it was too costly to deviate from the conventional behavior in a financially integrated world • Alternative policy options that would surprise financial markets can be risky to implement when consensus is strong • Paradoxically, monetary policy framework was too rigid while the world was moving towards more flexibility 6 Shifting Towards More Flexibility 7 The crisis was a wake-up call 8 The crisis was a wake-up call • It may be well worth to invest on crisis prevention • Monetary policy should not disregard financial stability aspects and asset price bubbles • The assessment of financial risks has to be broadened • The economy may not be as simple as previously thought 9 Re-emergence of Flexibility • Financial stability mandate in itself calls for more flexibility • Flexibility in reaction function • Flexibility in using alternative instruments • Thinking out of the box, contemplating richer view of welfare assessment and transmission mechanism • Search for an alternative policy framework • Unconventional is the new conventional? 10 Reflections on the Turkish Monetary Policy 11 In search of a new policy framework • Modify the existing inflation targeting regime to incorporate financial stability as a supplementary objective • But how? Implementation is not trivial. • Financial stability is a much broader concept than price stability • No past experience or role model • Lack of academic guidance 12 Main issues considered in the design of new policy-1 • Observation 1: Historically, Turkey is prone to boom-bust episodes driven by capital flows and excessive credit cycles 10 8 6 4 2 0 -2 -4 -6 Net Capital Flows/GDP Growth of GDP • 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 -8 Implication 1: The new policy should aim at alleviating the adverse impact of volatile capital flows and credit cycles on the domestic economy 13 Main issues considered in the design of new policy-2 • Observation 2: The volatility in cross-border financial flows has been excessively high in recent years (possibly due to QE and global uncertainty) 5300 Volatility of Stocks Flows to Emerging Countries Volatility of Bond Flows to Emerging Countries (right axis) 1300 4800 1100 4300 3800 900 3300 2800 700 2300 500 1800 1300 300 800 100 0105 0405 0705 1005 0106 0406 0706 1006 0107 0407 0707 1007 0108 0408 0708 1008 0109 0409 0709 1009 0110 0410 0710 1010 0111 0411 0711 1011 0112 300 • Implication 2: The new policy should be flexible enough to address volatile capital flows and sudden reversals in global risk appetite 14 Flexible Policy Designed by the CBRT 15 Flexibility in the objectives and instruments INSTRUMENTS OBJECTIVES OLD FRAMEWORK NEW FRAMEWORK Policy Rate Liquidity Management Interest Rate Corridor Policy rate Reserve Option Coefficients Price Stability Price Stability Financial Stability 16 Flexibility in the reaction function • Do not commit on a fixed interest rate for a predetermined period. • Full commitment boosts credibility under normal times, but perhaps not in these days and definitely not in an emerging economy. • Uncertain global outlook may prompt frequent reversals in policy stance. • It may be more credible not to promise on something you cannot deliver. • Credibility of ability 17 Flexibility in the reaction function: an example Interest Rate Corridor Overnight Repo Rates 14 12 10 8 6 4 2 0912 0712 0512 0312 0112 1111 0911 0711 0511 0311 0111 1110 0910 0710 0510 0310 0110 0 18 Implementation and Outcomes 19 Rapid credit growth and excessive currency appreciation by the end of 2010 Total Loan Growth Rates Real Exchange Rate (2003=100) (Annual Growth, Percent) 30% 140 25% 130 20% 120 15% 110 10% 100 5% 90 0% CPI Developing Countries Based CPI Developed Countries Based 0710 0110 0709 0109 0708 0108 0707 0107 0706 0106 0705 0105 0704 0104 0703 1110 1010 0910 0810 0710 0610 0510 0410 0310 0210 0110 1209 1109 1009 0909 0103 80 -5% *Total credit is inclusive of all types of banks (deposit banks, participation banks, and development/investment banks) and credit cards. 20 Current account balance by the end of 2010 (Seasonally Adjusted, Quarterly Average, Million USD ) 3.000 2.000 1.000 0 -1.000 Excluding Energy -2.000 -3.000 Current Account -4.000 -5.000 -6.000 1 2 3 2008 4 1 2 3 2009 4 1 2 3 4 2010 21 The response of the CBRT TL Reserve Requirement Ratios (Percent) CBT Policy Rates (Percent) 14 O/N Lending - Borrowing Interest Rate Corridor 1-week Repo Rate Average Cost of Central Bank Funding Overnight Repo Rates 12 The range of RRR Weighted average RRR 18 16 10 14 12 8 10 6 8 6 4 4 Adoption of New Policy Mix Oct-11 Aug-11 Jun-11 Apr-11 Feb-11 Dec-10 Oct-10 Aug-10 Jun-10 Sep-12 Jul-12 May-12 Mar-12 Jan-12 Nov-11 Sep-11 Jul-11 May-11 Mar-11 Jan-11 Nov-10 Sep-10 Jul-10 May-10 Mar-10 Jan-10 Apr-10 0 0 Aug-12 EU Debt Problems Jun-12 2 Apr-12 EU Debt Problems Feb-12 Adoption of New Policy Mix Dec-11 2 22 The outcome: credit growth and real exchange rate Total Loan Growth Rates (Annual Growth, Percent, FX Adjusted) Real Exchange Rate (Annual Growth, Percent) 150 45 Adoption of the new policy mix Adoption of the new policy mix 40 140 35 130 30 120 25 110 20 100 15 90 Developing Countries Based Index Developed Countries Based Index 80 0103 0603 1103 0404 0904 0205 0705 1205 0506 1006 0307 0807 0108 0608 1108 0409 0909 0210 0710 1210 0511 1011 0312 0812 0912 0712 0512 0312 0112 1111 0911 0711 0511 0311 0111 1110 0910 0710 0510 0310 0110 10 23 The outcome: current account and rebalancing GDP and Final Domestic Demand Current Account Balance (Seasonally Adjusted, 2008Q1=100) (Seasonally Adjusted, Quarterly Average, Million USD ) Current Account Balance GDP Current Account Balance (excluding energy) 4.000 Final Domestic Demand 115 2.000 110 0 105 -2.000 100 -4.000 95 -6.000 90 New Policy Mix New policy mix -8.000 85 -10.000 1 2 3 2008 4 1 2 3 2009 4 1 2 3 2010 4 1 2 3 2011 4 1 2 3* 2012 80 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 2005 2006 2007 2008 2009 2010 2011 2012 24 The outcome: inflation and expectations 14 Headline Inflation 24 Months Ahead Inflation Expectations 12 10 8 6 4 2 0712 0412 0112 1011 0711 0411 0111 1010 0710 0410 0110 1009 0709 0409 0109 1008 0708 0408 0108 1007 0707 0407 0107 1006 0706 0406 0 25 Concluding Remarks • The global crisis has dramatically shaked the consensus view in economics in many aspects. • Monetary policy across the globe has moved towards more flexibility. • The Central Bank of Turkey has formulated and implemented a more flexible strategy to address challenges posed by heightened global uncertainty and the ensuing volatility in cross border capital flows. • So far, the new policy mix has been successful in rebalancing the economy without hampering price stability objective. 26 Flexibility in Monetary Policy Hakan Kara Central Bank of the Republic of Turkey Presentation at ICOPEC Conference Kocaeli University September 27, 2012