2.1 Price Stability, Financial Stability and Monetary Policy

2.1.1 Overview

Despite the string of adverse shocks that it experienced in recent years, Turkey’s economy has been performing better than those of other developing countries. 2017 was a year in which the economic losses suffered in 2016 were recouped. During the first nine months of 2017, the country’s gross domestic product (GDP) increased by 7.4 percent as compared with the same period of the previous year. Among the principal factors supporting growth were the increased lending and improvements in domestic demand thanks to Treasury-backed Credit Guarantee Fund (KGF) guarantees and supportive macroprudential policies, the recovery in tourism revenues due to subdued geopolitical tensions, and the rise in goods exports owing especially to increased demand from European Union (EU) countries.

Annual inflation as of end-2017 was 11.92 percent, a figure that is outside the uncertainty band. The depreciation in the Turkish lira, developments in import prices and unprocessed food prices, and vigorous economic activity were the determinants of this inflation performance. Tax adjustments and real unit wages contributed less to inflation in 2017 than they did in 2016.

In the conduct of monetary policy in 2017, the CBRT sought to play a counter-balancing role all year long. Early in the year, the Bank tightened the monetary policy in order to curtail the upward risks to pricing behavior posed by volatilities in the exchange rate market. High levels of inflation and inflation expectations as well as developments in the core inflation outlook posed risks to pricing behavior, making it necessary to maintain this tight monetary policy stance for the rest of the year. Therefore, having gradually tightened monetary policy during the first four months of 2017, the CBRT subsequently maintained the same stance during the remaining eight. Nevertheless, the need for additional measures made itself felt towards the end of the year. The predictability of CBRT’s monetary policy was significantly enhanced by consistently directing much of the Bank’s funding through a single channel all year long in 2017.

2.1.2 Developments in 2017

Monetary Policy Developments

Exchange rate volatilities at the beginning of 2017 and their impact on the inflation outlook set the tone of monetary policy decisions in the first quarter of the year. Accordingly, at its January MPC meeting, the CBRT delivered a significant monetary tightening in order to curtail the deterioration in the inflation outlook. To this end, the CBRT raised its overnight lending rate to 9.25 percent from 8.5 percent and its Late Liquidity Window (LLW) lending rate to 11 percent from 10 percent. A variety of liquidity measures were also introduced in order to counter the adverse impact that the volatilities in the exchange rate market might have on price stability and financial stability. For example, the CBRT ceased to conduct its one-week repo auctions as of 12 January 2017; it began limiting the amounts of funding that it supplied via the Borsa Istanbul (BIST) Interbank Repo/Reverse Repo Market; it gradually reduced the borrowing limits that it assigned to banks taking part in its own Interbank Money Market (IMM); and it began meeting an increasingly greater portion of the system’s funding need through the LLW (Graph

In addition, the CBRT also took measures that would give it more flexibility in the management of foreign currency liquidity. Accordingly, it lowered the FX reserve requirement ratios; it launched a Foreign Exchange Deposits against Turkish Lira Deposits market; and it allowed export rediscount credits to be repaid in Turkish liras for a specific period.

By March, however, the cost-side pressures exerted by the cumulative depreciation of the Turkish lira were fueling a palpable rise in inflation notwithstanding the moderate trend in economic activity. Moreover, it was also anticipated that inflation would continue to rise in the short term owing especially to the base effect in unprocessed food prices. In view of these developments, at the March MPC meeting, the CBRT raised its LLW lending rate to 11.75 percent from 11.0 percent. Coordinated policy decisions made in the first quarter of the year sought to alleviate cost-side inflationary pressures stemming from exchange rates without imposing additional constraints on financial conditions. Indeed, as a result of the measures that were taken, improvements were observed in such financial benchmarks as exchange rate volatility, inflation compensation, and risk premiums in the first half of the year.


Despite a relative recovery in global financial conditions as of April, FX markets retained some of their volatility. However, the Turkish lira positively diverged from other developing countries’ currencies in that period, and recouped some of the losses which it had previously suffered. Thanks to macroprudential policies as well as government incentives and measures aimed at supporting the financial system, lending began to regain some vigor. Coming to the conclusion that the elevated level of inflation due to the lagged effects of Turkish lira depreciation, the rise in import prices, and the increase in food prices posed risks to pricing behavior, the CBRT decided at its April MPC meeting to further strengthen its monetary tightening. Consequently, the LLW lending rate was increased to 12.25 percent from 11.75 percent (Graph Beginning in June, it was apparent that global economic activity was indeed recovering. The upward revision in global economic growth projections and subdued volatility increased the global risk appetite in this period. As a result of this, portfolio flows to developing countries remained strong. Thanks to the KGF support, commercial loan growth accelerated, and economic activity gained strength owing to supportive incentives and measures. Nevertheless, high levels of inflation and inflation expectations as well as developments in the core inflation outlook posed risks to pricing behavior. Taking these risks into account, the CBRT decided to maintain its tight monetary policy stance in June and July while it gradually strengthened the level of monetary policy prudence through its communication in September and October.

In November, various liquidity measures were taken in order to counter the adverse effects that exchange rate market volatilities and price formations inconsistent with economic fundamentals might have on price stability and financial stability (Graph In line with this, the borrowing limits of banks taking part in the CBRT’s IMM were reduced to zero on their overnight transactions. As a result of this action, the CBRT was now providing all of its funding through its LLW channel as of 22 November and the Bank’s weighted average funding rate settled at 12.25 percent, which was identical to its LLW rate. Under its Reserve Options Mechanism (ROM), the CBRT lowered the upper limit of its FX facility to 55 percent from 60 percent and reduced all tranches by 5 percentage points, thereby providing the banking system with additional foreign currency liquidity. The Bank also announced that it would allow export rediscount credit borrowers to repay specified portions of their obligations in Turkish liras that were converted at fixed rates. On 20 November 2017, the CBRT additionally began conducting Turkish lira-settled forward foreign exchange auctions in order to effectively manage the real sector’s exchange rate risks and counteract any excessive volatilities that might take place in exchange rates.

The high levels of inflation witnessed at year-end as well as recent developments in costs continued to exacerbate both expectation and pricing-behavior risks. For this reason, the CBRT decided to continue tightening its monetary policy stance, and at its December MPC meeting the Bank raised its LLW lending rate to 12.75 percent from 12.25 percent.

Paralleling this increasingly tighter monetary policy stance, the yield curve shifted upwards at all maturities but most pronouncedly in the shorter ones, especially during the last quarter of the year (Graph Between the middle of September and the end of November, Turkey’s country risk premium diverged somewhat negatively from that of other developing countries due to geopolitical developments in its region. However, in December, Turkey’s risk premium improved owing in part to increases in the global risk appetite but also to diminishing geopolitical risks and CBRT’s monetary tightening efforts (Graph

Performance improvements observed in global economic activity and signals that the process of monetary policy normalization in developed countries was likely to be moderate prompted strong and steady portfolio investment flows towards developing countries in 2017. Having lost momentum in the September-November period, inward portfolio investments in Turkey began to rise again in response to recent reductions in exchange rate market volatilities and in geopolitical risks. Indeed, when we look at the cumulative growth in such investments since the beginning of 2017, we see that portfolio investment inflows in Turkey were well above historical averages (Graph

Thanks to macroprudential policies in support of the financial system as well as to public finance measures and incentives, there was a marked growth in credits in 2017 (Graph In the last quarter of the year, the fact that Treasury-backed KGF lending was approaching previously-announced limits had the effect of making the rebalancing process in commercial credits continue, with the result that overall credit growth during the last three months remained flat.

Inflation Developments

Annual inflation weighed in at 11.92 percent as of end-2017, a figure that is outside the uncertainty band (Graph The depreciation in the Turkish lira, developments in import prices and unprocessed food prices, and vigorous economic activity were the determinants of this inflation performance. Tax adjustments and real unit wages contributed less to inflation in 2017 than they did in 2016.

The consumer price index (CPI) and annualized core inflation indicators have been moving upwards in Turkey since November 2016. Although inflation initially appeared to subside somewhat owing to waning base effects, both CPI inflation and core inflation continued to rise as of July. The volatilities during the year were attributed to developments in the energy and food groups. Cost-side inflationary pressures stemming from developments in exchange rates and in oil and other input prices were quite evident in the core goods and energy groups. Besides these cost-side pressures, core goods inflation fueled by higher customs duties on a number of goods (personal care products, garments, etc.) and by a deterioration in pricing behavior made the most salient contribution to overall inflation. The effects of exchange rate depreciation were also to be seen in the food and services subgroups in 2017.

The course of annual inflation in the food group fluctuated due to base effects. While much of this volatility stemmed from the unprocessed food group and was particularly the result of movements in fresh fruit and vegetable prices, the depreciation of the Turkish lira also adversely affected food inflation, whose net contribution to overall inflation was more serious in 2017 than it was in 2016. Late-in-the-year measures taken by the Food Committee began to have a measurable impact on unprocessed food prices. The downward support provided to inflation by demand conditions associated with the strong course of economic activity disappeared as of the second quarter of 2017.

Owing to cost shocks and the overall inflation outlook, medium-term inflation expectations began to deteriorate in the last quarter of 2016 and this trend continued all year long in 2017. Despite staying relatively flat throughout the second and third quarters of 2017, inflation expectations remained high and they worsened noticeably with the rapid depreciation of the Turkish lira in the last quarter of the year (Graph Overall, 2017 was a year in which heightened inflation expectations had a significant impact on price-adjustment behavior.

GDP Developments, Rebalancing Process, and Labor Market

According to data with base year 2009 published by the Turkish Statistical Institute (TurkStat), Turkey’s GDP grew by 3.2 percent in 2016. The country’s goods exports and tourism industry were adversely affected that year by geopolitical tensions as well as by incidents of terrorism and by rocky relations with Russia.

On the other hand, 2017 was a year in which the economic losses suffered in 2016 were recouped. During the first nine months of 2017, the country’s GDP increased by 7.4 percent as compared with the same period of the previous year (Graph With priority being given to restoring confidence in the national economy, a total of TL 200 billion in credit was supplied to small- and medium-sized enterprises (SME) through the Credit Guarantee Fund. Besides a recovery in tourism revenues in the wake of diminished geopolitical tensions, growth was also supported by demand-driven increases in goods exports, especially those going to EU countries.

Growth in the current account deficit after the second quarter of 2016 was driven primarily by gold imports. When gold imports are factored out, Turkey’s balance of payments had actually improved from the end of 2011 until the third quarter of 2017. Looking at a sectoral breakdown, we see that the strong performance in gold-excluded exports, particularly led by exports by the motor vehicles and iron & steel sectors, played a significant role in the improvement of the current account deficit. These two sectors’ solid export performance was supported by robust demand coming from EU countries. The improvement in the non-gold current account balance was helped by a strong recovery in tourism revenues but was hampered by both higher energy prices and by a drop in the country’s terms of trade (Graph

Real effective exchange rates fell by an average of 10 percent in 2017 as compared with the previous year. This decline in real exchange rates in a year of relatively vigorous domestic demand is what also contributed to the improvement in the current account deficit by helping to rein in rises in imports (Graph

Unemployment rates appear to have been in decline from the beginning of 2017 onward (Graph While robust economic activity along with rises in non-agricultural employment contributed substantially to this downtrend, it was constrained by the increase in the labor force participation rate (Graph Growth in non-agricultural employment in the first nine months of 2017 was driven by services and construction sectors whereas employment rates in the manufacturing industry remained rather low.

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