Inflation Report - TCMB

Inflation Report

2018-III

Contents

1. OVERVIEW 1

1.1 Monetary Policy and Financial Markets 2 1.2 Macroeconomic Developments and Main Assumptions 4 1.3 Inflation and the Monetary Policy Outlook 7 1.4 Key Risks to Inflation Forecasts and the Likely Monetary Policy Response 9

2. INTERNATIONAL ECONOMIC DEVELOPMENTS 11

2.1 Global Growth 11 2.2 Commodity Prices and Global Inflation 14 2.3 Global Monetary Policy 17 2.4 Global Risk Indicators and Portfolio Flows 18

3. INFLATION DEVELOPMENTS 25

3.1 Core Inflation Outlook 26 3.2 Food, Energy and Alcohol-Tobacco Prices 30 3.3 Domestic Producer Prices 32 3.4 Agricultural Producer Prices 34 3.5 Expectations 35

4. SUPPLY AND DEMAND DEVELOPMENTS 43

4.1 Supply Developments 43 4.2 Demand Developments 45 4.3 Labor Market 47 4.4 Wages and Productivity 50 4.5 Output Gap 52

5. FINANCIAL CONDITIONS AND MONETARY POLICY 63

5.1 Relative Performance of Financial Markets 64 5.2 Credit Conditions 65 5.3 Monetary Policy 69

6. PUBLIC FINANCE 77

6.1 Budget Developments 77 6.2 Developments in the Public Debt Stock 80

7. MEDIUM-TERM PROJECTIONS 83

7.1 Current State, Short-Term Outlook and Assumptions 83

7.2 Medium-Term Forecasts 87

7.3 Key Risks to Inflation Forecasts and the Likely Monetary Policy Response 89

BOXES

Box 2.1 Monetary Policy Normalization in Advanced Economies: Current Phase and Expectations 21

Box 3.1 Tax Change in Tobacco Products and Its Repercussions on Inflation 37

Box 3.2 Structural Problems in Unprocessed Food Inflation and Policy Recommendations 40

Box 4.1 Decomposition of Output Gap into its Demand Components 53

Box 4.2 Products Subject to Project-Based Incentive System and Possible Effects on the Current Account Balance

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Box 4.3 Nowcasting Turkish GDP Growth: MIDAS Approach 58

Box 5.1 Country Risk Premium and Macroeconomic Conditions When Global Financial Conditions are Tighter

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Box 7.1 Interaction of Monetary and Fiscal Policies 94

Overview

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1. Overview

In the first half of the year, global growth stabilized and remained strong (Chart 1.1). The growth in the US economy was more stable, whereas growth in the euro area, Japan and the UK decelerated in the first quarter, prompting downward revisions to their year-end inflation expectations. Growth prospects have varied across emerging economies due to weakening currencies, rising oil prices and increasing protectionist tendencies in international trade. Despite rising commodity and energy prices, consumer and core inflation rates have been moderate globally. Amid positive growth performance and accommodative fiscal policies, the US Federal Reserve (Fed) seems more likely to speed up the monetary policy normalization compared to the previous reporting period, and this has driven US bond yields higher. The appreciation of the US dollar has recently triggered fluctuations in global financial markets. The deteriorating risk sentiment towards emerging markets led to weaker portfolio inflows, depreciation in currencies and higher volatility in the second quarter (Chart 1.2).

Chart 1.1: Global Growth Rates* (Annual % Change) Chart 1.2: Portfolio Flows to Emerging Economies (Billion USD, 4-Week Cumulative)

Source: Bloomberg, CBRT.

* Weighted by each country’s share in global GDP.

Source: EPFR.

In the second quarter of 2018, Turkey's risk premium and exchange rate indicators diverged negatively from other emerging economies due to turbulent global financial markets and rising emerging market risk premiums aggravated by domestic uncertainties, a widening current account deficit and rising inflation. In response to tighter financial conditions, banks tightened their standards for commercial loans in the second quarter, and commercial loan demand decreased with the additional impact of the slowdown in economic activity. Thus, loan growth continued to decrease in the second quarter.

Consumer inflation accelerated to 15.4 percent in the second quarter. The rise in inflation was widespread across all subcategories, with food, core goods and energy in the lead. Core inflation indicators also deteriorated significantly while the tendency to raise prices increased. Even if the impact of aggregate demand conditions on inflation started to wane gradually as of the second quarter, cost-side pressures and the deteriorated pricing behavior affect the inflation outlook adversely. In the first quarter, economic activity was slightly stronger than envisaged in the April Inflation Report, with private consumer spending being the main driver of growth. Economic activity seems to be rebalancing as of the second quarter owing to decelerating domestic demand, while the recovery in tourism helps net exports provide further contribution to growth.

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Inflation Report | 2018-III

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1.1 Monetary Policy and Financial Markets After a 75-basis point rate hike at the MPC meeting in April, the CBRT tightened monetary policy two more times, introducing an additional tightening of 425 basis points in total. In the inter-reporting period, the CBRT first raised the Late Liquidity Window (LLW) lending rate by 300 basis points at the interim meeting on 23 May 2018, emphasizing that the unhealthy price formations in the market and persisting rise in inflation expectations posed risks to the general pricing behavior (Chart 1.1.1). Moreover, to improve the predictability of monetary policy and strengthen the monetary transmission mechanism, the Bank announced in a press release dated 28 May 2018 that it had decided to complete the simplification process regarding the operational framework of the monetary policy to be effective as of 1 June 2018. Accordingly, the Bank set the one-week repo rate as its new policy rate and primary funding channel (Chart 1.1.2) and adopted a framework in which overnight market rates would be determined around the policy rate within a symmetrical corridor of overnight borrowing and lending rates. At the MPC meeting in June, the Bank highlighted that high inflation and inflation expectations continued to pose risks to pricing behavior, and decided to further tighten monetary policy by hiking the policy rate to 17.75 from 16.50 percent (Chart 1.1.1). At the July meeting, however, the Bank kept its monetary policy stance unchanged considering the need to monitor the slowdown in domestic demand and the lagged effects of monetary policy, but nevertheless stated that monetary policy may have to remain tight for an extended period as high inflation and inflation expectations continue to pose risks to pricing.

Chart 1.1.1: Short-Term Interest Rates (%) Chart 1.1.2: CBRT Funding (2-Week Moving Average, Billion TL)

Source: BIST, CBRT. Source: CBRT.

The monetary tightening in May and June and Turkey’s rising risk premium pushed currency swap rates up across all maturities in the inter-reporting period (Chart 1.1.3). In addition, the yield curve assumed a more negative slope, suggesting tighter monetary conditions compared to both the previous reporting period and peer economies. Due to the deteriorated risk sentiment towards emerging economies along with geopolitical tensions, and worries over the domestic macroeconomic outlook, the implied volatility of the Turkish lira significantly increased compared to the April Inflation Report period (Chart 1.1.4).

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Overview

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Chart 1.1.3: Swap Yield Curve (%) Chart 1.1.4: Implied FX Volatility (1-Month-Ahead, %)

Source: Bloomberg. Source: Bloomberg.

* Emerging market currencies include those of Brazil, Indonesia, the Philippines, South Africa, India, Colombia, Hungary, Malaysia, Mexico, Poland, Romania and Chile.

Growth in commercial loans slowed in the second quarter due to tighter loan standards and weaker loan demand whereas growth in consumer loans slightly accelerated thanks to mortgage promotions (Chart 1.1.5). All components, the slope of the yield curve and the risk premium in particular, contributed to the tightening of the Financial Conditions Index (FCI), which suggested a significant tightening in the second quarter (Chart 1.1.6).

Chart 1.1.5: Annual Loan Growth (Adjusted for Exchange Rates, YoY % Change)

Chart 1.1.6: Contributions to FCI*

Source: CBRT. Source: CBRT.

* For further details on measuring the FCI, see the CBRT Working Paper No. 15/13.

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1.2 Macroeconomic Developments and Main Assumptions Inflation

Consumer inflation was up 5.2 points from the end of the first quarter to 15.4 percent in the second quarter of 2018, a level significantly higher than the April forecast (Chart 1.2.1). A similar pattern was observed in the forecast for the CPI excluding unprocessed food, alcohol and tobacco (Chart 1.2.2). The recent cost-side developments and fluctuations in food prices have been affecting inflation. Price hikes spread across all subcategories. The depreciating Turkish lira as well as the rise in oil and commodity prices contributed to this result as well. Albeit weakening, demand conditions continued to put pressure on inflation in the second quarter.

Chart 1.2.1: April Inflation Forecast and Actual Inflation* (%)

Chart 1.2.2: Forecast and Actual Inflation Rates for Inflation excl. Unprocessed Food, Alcoholic Beverages and Tobacco Products* (%)

Source: CBRT, TurkStat. Source: CBRT, TurkStat.

* Shaded area denotes the 70 percent confidence interval for the forecast.


In the second quarter, the main factor pushing annual inflation was the core goods group. Cumulative exchange rate effects and strong aggregate demand conditions added to this outlook. Moreover, the rise in the contribution from food, services and energy was significant. The higher-than-expected increase in annual food inflation was mainly driven by unprocessed food prices that rose on the back of exchange rate developments and supply shortages in some agricultural products. Meanwhile, annual services inflation was driven higher by several factors such as the weaker Turkish lira, backward-indexation, worsening food inflation, the buoyant tourism industry and real unit labor costs (Chart 1.2.3). Energy inflation accelerated due to both exchange rate effects and higher international oil prices, nevertheless the new sliding-scale pricing implementation for fuel curbed further increase in energy prices.

As producer inflation hit 23.7 percent at the end of the second quarter, cost pressures on consumer prices significantly increased. In this period, the impact of demand conditions on inflation still exerted an upward pressure despite the diminished effect compared to the previous quarter. Moreover, the ongoing robust outlook in the tourism sector increases inflation pressures on the sectors tightly affiliated to this sector. In this period, both core inflation indicators and inflation expectations deteriorated significantly. Due to high inflation rates and rising inflation expectations, pricing behavior deteriorates and the tendency for price hikes grows stronger in excess of demand and cost pressures in the economy. Actually, diffusion indices reveal that economic units have a growing tendency to raise prices (Chart 1.2.4). In sum, trend indicators and pricing behavior suggest a notable deterioration in the underlying trend of inflation.

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April IR Forecast Realization

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Overview

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Chart 1.2.3: Prices of Core Goods and Services (Annual % Change)

Chart 1.2.4: Diffusion of B and C Indices (Seasonally Adjusted 3-Month Average)

Source: TURKSTAT. Source: CBRT, TURKSTAT.

Supply and Demand

In the first quarter of 2018, economic activity remained robust, slightly stronger than projected in the April Inflation Report (Chart 1.2.5). Gross Domestic Product (GDP) increased by 2.0 percent on a quarterly basis and 7.4 percent on an annual basis in this quarter.

In the first quarter, quarterly and annual growth were both mainly driven by domestic demand (Chart 1.2.6). The improvement in the labor market led to an acceleration in private consumption, while public consumption offered less support to growth. In this quarter, investments contributed to annual growth through machinery-equipment and construction investments; while investments’ contribution to quarterly growth came only from the rise in construction investments and the contraction in machinery-equipment investments deepened. The contribution of net exports proved negative to annual growth, but positive to quarterly growth, the latter being driven by the significant fall in imports.

Chart 1.2.5: GDP and Domestic Demand (Real, Seasonally Adjusted, 2009=100)

Chart 1.2.6: Contributions to Annual GDP Growth from the Expenditures Side (% Points)

Source: CBRT, TURKSTAT. Source: CBRT, TURKSTAT.

* Other includes changes in inventories and statistical discrepancy due to the use of chain-linked index.

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Data for the second quarter suggest that economic activity has decelerated and started rebalancing. The possible deceleration particularly in the construction sector as well as services sectors that are not subject to foreign trade is expected to have negative repercussions on the labor market, and indicators suggest an increase in unemployment rates (Chart 1.2.7). In this period, the depreciation in the Turkish lira accompanied by the increased financial volatility, perceptions of uncertainty and financing costs as well as the uptrend in inflation are projected to decelerate domestic demand via the consumption and investment expenditures channels. Meanwhile, the public sector’s supportive stance for economic activity through expenditures and other fiscal measures is expected to limit the slowdown in domestic demand to some extent in the second quarter. On the other hand, recovery in tourism continues strongly and net exports continue to underpin growth due to the slowdown in import demand resulting from the subdued domestic demand. Rising import prices, particularly oil, weigh on the current account balance further, while the slowing domestic demand restricts the deterioration in the current account balance excluding gold and energy (Chart 1.2.8).

In the second half of 2018, economic activity is projected to continue rebalancing. Owing to the cumulative depreciation in the real exchange rates, the strong rebound in tourism and the favorable course of global growth, it is likely that exports of goods and services will continue to underpin growth and affect the current account balance positively. Nevertheless, the slowdown in economic activity will have an adverse impact on the labor market and thus, unemployment rates will rise slightly.

Chart 1.2.7: Unemployment Rates (Seasonally Adjusted, %)

Chart 1.2.8: Current Account Balance (CAB) (12-Month Cumulative, USD Billion)

Source: TURKSTAT. Source: CBRT.

* April period.

Oil, Import and Food Prices

Led mainly by energy and industrial metal prices, commodity prices on international markets remained on the rise in the second quarter. Due to the rise in crude oil prices in the second quarter, assumptions for crude oil prices in the medium-term forecasts in the April Inflation Report were revised upwards from USD 68 to USD 73 for 2018, and from USD 65 to USD 73 for 2019 (Chart 1.2.9). The assumptions for average annual increase in import prices in USD terms were revised upwards for 2018 and 2019 on account of the recent developments (Chart 1.2.10).

Unprocessed food inflation surged by 16.9 percent quarter-on-quarter and hit 23.2 percent at the end of the second quarter of 2018, significantly exceeding the assumptions cited in the April Inflation Report. Unprocessed food inflation is assumed to converge to its historical averages and decline to 12 percent at the end of the year as prices of some vegetables and fruits are expected to normalize with the supply of new products in the upcoming period. Accordingly, the food inflation forecast was revised upwards to 13 percent from 7 percent for end-2018, and to 10 percent from 7 percent for end-2019.

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Overview

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Chart 1.2.9: Revisions in Oil Price Assumptions* (USD/bbl) Chart 1.2.10: Revisions in Import Price Assumptions* (Index, 2010=100)

Source: Bloomberg, CBRT. Source: Bloomberg, CBRT.

* Shaded area denotes the forecast period. * Shaded area denotes the forecast period.

Fiscal Policy and Tax Adjustments

Fiscal policy remained supportive of economic activity in the second quarter, while some arrangements on administered prices and tax adjustments curbed further rise in inflation. Forecasts are based on the scenario that the arrangement introduced to stabilize fuel prices will continue until the end of the year. On the other hand, it is assumed that energy items excluding fuel will witness price adjustments at higher rates in the third quarter than those envisaged in the April Inflation Report.

Medium-term projections are based on a framework entailing a fiscal policy focused on lowering inflation in the medium term and conducted in coordination with the monetary policy. Accordingly, it is assumed that the support of the public sector for economic activity will be replaced by a neutral stance, and the prices and wages controlled by the government will be set broadly consistent with inflation targets to reduce backward-indexation. The strong policy coordination to lower inflation and achieve macroeconomic rebalancing is envisaged to gradually improve the risk premium and uncertainty perceptions.

1.3 Inflation and the Monetary Policy Outlook With a tight policy stance that focuses on bringing inflation down through enhanced policy coordination, inflation is projected to converge gradually to the target. Accordingly, inflation is projected to be 13.4 percent at the end of 2018 and then fall to 9.3 percent at the end of 2019, 6.7 percent at the end of 2020, stabilizing around 5 percent over the medium term. Thus, with a 70 percent probability, inflation is expected to be between 12.5 percent and 14.3 percent (with a mid-point of 13.4 percent) at end-2018, between 7.6 percent and 11.0 percent (with a mid-point of 9.3 percent) at end-2019 and between 4.8 percent and 8.6 percent at the end of 2020 (with a mid-point of 6.7 percent) (Chart 1.3.1). Forecasts are based on an outlook that the tight monetary policy stance will be maintained for an extended period.

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Chart 1.3.1: Inflation and Output Gap Forecasts*

Source: CBRT, TURKSTAT.


The annual consumer inflation forecast for end-2018 has been revised upwards to 13.4 percent, indicating a 5-point rise compared to April Inflation Report. Of this rise, 2.3 percentage points came from the revision in import price assumption in TL terms because of the developments stemming from oil prices and exchange rates. In this revision, the impact of oil and exchange rate-induced cost factors on energy prices other than fuel has been included as well. Food inflation, which was revised upwards from 7 percent to 13 percent, contributes to the revision in end-year consumer inflation forecast by 1.4 percentage points. The high inflation forecast discrepancy coupled with the deterioration in pricing behavior is estimated to add 1.3 percentage points to the inflation forecast. The rise in the prices of alcoholic beverages -on the back of the increased special consumption tax- constitutes 0.1 percentage points of the total revision. The output gap estimates, which are revised downwards compared to the previous reporting period, are expected to decrease the end-2018 consumer inflation forecast by 0.1 percentage points.

Meanwhile, the inflation forecast for end-2019 has been revised upwards from 6.5 percent to 9.3 percent. Of the 2.8-point upward revision in end-2019 inflation forecast compared to the April Inflation Report, 1.5 percentage points stemmed from the upward revision in oil and import price assumptions in TL terms, whereas 0.7 percentage points came from the revision in food prices assumption from 7 percent to 10 percent. While adjustment for the higher inflation outturn and deterioration in the underlying trend drove the forecast 1 percentage point higher, the downward revision in the output gap decreased the forecast by 0.4 points.

In the forecast framework described above, annual consumer inflation is projected to display a modest rise in the third quarter and to fall in the final quarter to 13.4 percent at the end of the year. Under the assumption that there will be no additional rise in Turkey’s risk premium driven by global or domestic developments, the disinflation process throughout 2019 will be supported by the tight monetary policy stance and the determined implementation of inflation-oriented policy coordination, as well as economic activity and loan growth converging to a milder path.

With a view to reduce the tradeoffs regarding disinflation in the current juncture and to enhance the resilience of the Turkish economy, and also considering the high levels of inflation and elevated global risks, the prospective contribution from fiscal and macroprudential policies to the rebalancing process is of critical importance (Box 7.1). The main outlook is based on a framework in which the negative divergence of risk perceptions regarding Turkey would be largely taken back so that depreciation

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Overview

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pressures on the Turkish lira would be alleviated as a result of the macro policy mix formulated in a coordinated way prioritizing the disinflation process. Accordingly, a moderate appreciation trend was assumed in the real exchange rate. Moreover, while formulating forecasts, it was envisaged that this policy coordination would stop the extended deterioration in inflation expectations and contribute in particular to the gradual convergence of medium-term inflation expectations to the target.

The enhanced coordination between macroeconomic policies is judged to alleviate the decelerating impact of increased financial volatility and uncertainty perceptions on domestic demand and limit the tightening of financial conditions. Therefore, the output gap estimates for the second and third quarters, which were revised downwards significantly compared to the April Inflation Report, are projected to trend down moderately in the fourth quarter. The economic activity is expected to start contributing to disinflation in the second half, as domestic demand decelerates. Output gap forecasts for 2019 are lower compared to the April Inflation Report, and imply an outlook where economic activity gradually recovers and converges to the underlying trend.

1.4 Key Risks to Inflation Forecasts and the Likely Monetary Policy Response The outlook that the medium-term projections presented in the Inflation Report is based on the Monetary Policy Committee’s judgments and assumptions. Nevertheless, various risks to these factors may affect the inflation outlook and necessitate changes in the monetary policy stance envisaged in the baseline scenario.

Risks to the medium-term inflation outlook are mostly on the upside. Risks that have the potential to change the outlook that the baseline scenario hinges on are as follows:1

Risks to the effectiveness of the coordination between the monetary and fiscal policies;

A deterioration in pricing behavior and expectations formation;

Weaker capital flows towards emerging market economies;

Persisting volatilities in financial markets stemming from domestic factors;

Further supply-side tightening in bank loans;

Likely adverse impacts of global protectionist trade policies on economic activity, trade volume and prices;

Rise in crude oil import prices;

Sustained rise in food prices.

A weaker coordination between monetary and fiscal policy than in the baseline scenario is regarded as a risk with respect to disinflation and macroeconomic rebalancing. This coordination has two pillars. Firstly, it is important that the administered prices, tax adjustments and incomes policies are formulated in a way to help diminish the backward-indexation behavior. The second pillar is to implement countercyclical fiscal policy to ensure the rebalancing of the economy. The demand-side pressures on prices may continue if the supportive impact of expansionary fiscal policy measures on domestic demand and economic activity persists. Amid further tightening in global financial conditions and also taking into account the current high levels of inflation and the current account deficit, this would lead to a climb in Turkey’s risk premium, an increased pressure on exchange rates, and hence, a tighter monetary policy stance would be required to decrease inflation.

Another important risk to inflation outlook in the upcoming period would be further deterioration in the pricing behavior. Under a conjuncture of high inflation rates and risk premium level and in case of a failure in implementing the macroeconomic rebalancing process rapidly and effectively, inflation and

1 The channels through which these risks may change inflation outlook are summarized in Table 7.3.1 in Chapter 7.


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exchange rate expectations may feed each other and undermine the disinflation process. In such a case, any further deterioration in the pricing behavior may necessitate a tighter monetary policy stance for longer in order to lower inflation.

Moreover, there are also risks stemming from global monetary policies and risk appetite developments that may lead to a decline in capital flows towards emerging economies and feed into exchange rate volatility. If unhealthy price formations and excessive volatility occur in the markets due to fluctuations in global liquidity conditions, the CBRT may continue using liquidity measures intended for providing the FX liquidity needed in the market in a timely, controlled and effective manner, and it may introduce additional tightening in monetary policy to curb the impact of these risks on inflation and inflation expectations.

Although the forecasts in the previous section are based on an outlook of moderately slowing economic activity, in the case of high market volatility and additional depreciation of the Turkish lira, firms’ cash flows and balance sheets may be adversely affected and financial conditions may tighten further. Likewise, a significant deceleration in the rate of increase in house and commercial real estate prices may decrease the value of collaterals that the firms put up against loans and firms may be exposed to tighter credit conditions. Should the risks mentioned materialize, they could lead to a more significant slowdown in economic activity than envisaged. The policy mix that would be employed in such a case will be very important for preventing the financial conditions from falling into an unproductive tightening cycle. A strong coordination to be established between the financial sector policies addressing the balance sheet effects in particular and the monetary policy focusing on inflation will enhance the effectiveness of the policies.

On a global scale, the likely adverse impact of protectionist trade policies on economic activity, trade volume and prices may have a downward impact on inflation in Turkey mainly through the external demand channel. On the other hand, if these trade policies cause a rise in global inflation, countries involved in trade protectionism may tighten their monetary policies and the global risk appetite may deteriorate. In this case, the likely depreciation in Turkish lira will necessitate a policy response proportionate to the impact of this depreciation on inflation.

There are also supply-side risks to food and crude oil prices that may affect inflation adversely. The CBRT's monetary policy response will be determined in such a way to curb a possible deterioration in inflation expectations and pricing behavior, taking into account the direct and secondary effects of respective risks on inflation.

International Economic Developments

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2. International Economic Developments Data for the first half of the year suggest that global growth has stabilized and remained strong. Across advanced economies, the US growth was more favorable and stable whereas growth in the euro area, Japan, and the UK decelerated in the first quarter of the year, prompting a downward revision in year-end forecasts. The pressure on emerging market currencies due to increasing yields in the US, rising oil prices, and intensified global protectionism in foreign trade are causing growth prospects in emerging economies to diverge across countries as well. As for the upcoming period, due to geopolitical developments and significantly increasing protectionism in foreign trade, downside risks to the global growth outlook are more evident. The decision of the US in early June to extend the list of countries that will be subject to additional tariffs in imports of iron-steel and aluminum strengthens the probability of a global increase in protectionism in foreign trade. Accordingly, the countries in question raise the possibility of taking counteractions that will contract global trade. The fact that these additional tariffs will also be applicable to European Union countries coupled with political uncertainties keeps the downside risks to economic activity in the euro area, an important driver of global growth, alive.

Despite the rise in commodity and energy prices due to positive global growth, consumer and core inflation rates continue to follow a moderate course. Nevertheless, geopolitical developments and uncertainties about foreign trade policies may pose an upward risk to commodity prices, particularly energy and metal prices. Moreover, the likelihood of an acceleration in wages in advanced economies is also one of the most important risk factors for inflation.

Financial conditions in advanced economies have tightened since the previous Inflation Report period. In particular, the ongoing positive growth performance and the new tax law in the US that can be seen as an expansionary fiscal policy set the ground for the Fed to expedite the monetary policy normalization process. In this respect, the probability of a total of four rate hikes by the Fed in 2018 has significantly increased compared to the previous reporting period, leading to a surge in US bond yields. Due to the appreciating US dollar, global financial markets fluctuated in the recent period, risk perceptions about emerging economies worsened, the depreciation and volatility in exchange rates increased, and portfolio flows weakened in the second quarter of the year. Given the tight financial conditions in advanced economies, lingering geopolitical uncertainties, and possible negative effects of increased protectionism in world trade, portfolio flows to emerging economies are expected to continue deteriorating also in the upcoming period.

Uncertainties regarding the global economic policies, contractionary global foreign trade policies, and geopolitical risks narrow the growth potential of the global economy. Therefore, to reduce vulnerabilities, it is important that macroeconomic policies are implemented effectively and in coordination and also supported by structural reforms and appropriate trade policies.

2.1 Global Growth The positive growth trend in global economic activity continued from 2017 overall through the first quarter of 2018 when the global economy grew at the same rate as in the previous quarter (Chart 2.1.1). The favorable growth performance in both advanced and emerging economies relative to the previous quarter was influential in this development. In this period, the largest contribution to the growth in advanced economies came from the US whereas the euro area, Japan, and the UK registered a slightly decelerated rate of growth compared to the previous quarter. On the emerging economies front, China and India were the fastest-growing countries whereas the growth rate in Brazil significantly decreased compared to the previous quarter. Analyzing the growth rates of emerging economies by regions, the growth performance in Asia, Latin America, and Eastern Europe was on a far more favorable track in the first quarter of the year than in the previous quarter (Chart 2.1.2).


12

Chart 2.1.1: Global Growth Rates* (Y-o-Y % Change) Chart 2.1.2: Regional Growth Rates for Emerging Economies* (Y-o-Y % Change)


* Weighted by each country’s share in global GDP. * Weighted by each country’s share in regional GDP.

Global PMI data for the second quarter of the year suggest a worse growth performance for the manufacturing industry and a better growth performance for the services sector relative to the first quarter (Chart 2.1.3). In this period, the manufacturing industry PMI in the US rose quarter-on-quarter. The improvement in the PMI indicator and the developments in the labor market both indicate that the positive growth prospect in the US economy continues in the second quarter and raise an expectation that the growth rate will be higher than the previous quarter. Moreover, it can be said that the new tax law enacted on 1 January, which introduced cuts in both income and corporate tax rates, favorably affected domestic demand and accordingly the economic growth in the US. In fact, the historically high levels of consumer confidence indices are a testimony to this judgment. Conversely, data for the manufacturing industry PMI in the euro area and Japan recorded a quarter-on-quarter decrease in the second quarter of the year (Chart 2.1.4). These data demonstrate that the positive growth performance in the euro area slightly weakened and the deceleration in the growth rate of Japan continued in the second quarter. A similar case is also observed in the UK and Canada.

Chart 2.1.3: Global PMI Chart 2.1.4: Manufacturing Industry PMI in Advanced Economies

Source: IHS Markit. Source: IHS Markit.

-1

1

3

5

7

9

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 3 4 1

2010 2011 2012 2013 2014 2015 2016 2017 18

Emerging Economies

Advanced Economies

Global GDP

-3

0

3

6

9

12

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 3 4 1

2010 2011 2012 2013 2014 2015 2016 2017 18

Latin America

Asia

Eastern Europe

48

50

52

54

56

58

06

.10

06

.11

06

.12

06

.13

06

.14

06

.15

06

.16

06

.17

06

.18

Services Manufacturing

40

45

50

55

60

65

06

.10

06

.11

06

.12

06

.13

06

.14

06

.15

06

.16

06

.17

06

.18

Euro Area USA Japan


13

In the second quarter of the year, PMI indicators for emerging economies posted a quarter-on-quarter decrease in the manufacturing industry and the services sector (Chart 2.1.5). This decrease was triggered by the worsening PMI data in Latin American countries, particularly in Brazil. This was also the case in Eastern Europe. However, PMI indicators displayed a favorable outlook in Asia, particularly in India. In light of these data, emerging economies are projected to have a slower growth performance, caused primarily by Latin America, in the second quarter compared to the first quarter, posting a growth rate below that of the first quarter.

Chart 2.1.5: Emerging Markets PMI

Chart 2.1.6: Export-Weighted Global Production Index* (Y-o-Y % Change)

Source: IHS Markit. Source: Bloomberg, CBRT.

* Weighted by each country’s share in Turkey’s exports.

** Average growth forecast for 2018.

In sum, the favorable growth trend in the global economy is estimated to continue in the second quarter

of the year but at a decelerated rate compared to the previous quarter. In this period, the main drivers of global growth are expected to be the US on the advanced economies front, and China and India on the

emerging economies front.

Regarding the second half of the year, it is expected that the positive growth trend will continue in the US

whereas growth performance in the euro area will somewhat fall. This expectation is reinforced by the

fact that compared to the previous reporting period, year-end growth forecasts have been revised

upwards for the US and downwards for the euro area according to July Consensus Forecasts bulletins. As

for emerging economies, capital outflows are expected to continue from the second quarter through the

second half of the year and adversely affect the growth performance of these countries. In fact, 2018

year-end growth forecasts for Latin America have been revised significantly downwards compared to the

previous reporting period (Table 2.1.1). In this context, growth rates in emerging economies, Latin

American countries in particular, are estimated to continue losing pace in the second half of the year.

The global growth forecast for end-2018 remained the same as in the previous reporting period

(Table 2.1.1). However, the annual growth rate of the export-weighted global production index, which

was revised by the July growth forecast, moderately decelerated compared to the April Inflation Report

(Chart 2.1.6). This deceleration was primarily due to the downward revision in the year-end growth

forecast for the euro area. Accordingly, although Turkey's foreign demand outlook for 2018 slightly

weakened compared to the previous reporting period particularly due to euro area, it nevertheless

remained positive.

48

50

52

54

56

58

06

.10

06

.11

06

.12

06

.13

06

.14

06

.15

06

.16

06

.17

06

.18

Services Manufacturing

-6

-4

-2

0

2

4

6

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 3 4 1 2 3 4

2010 2011 2012 2013 2014 2015 2016 2017 2018

July 2018 Forecast**: 2,64

April 2018 Forecast**: 2,88


14

Table 2.1.1: Growth Forecasts for 2018 and 2019 (Annual Average % Change)

April July

2018 2019 2018 2019

Global 3.3 3.2 3.3 3.2

Advanced Economies

USA 2.8 2.6 2.9 2.6

Euro Area 2.4 1.9 2.2 1.8

Germany 2.4 1.9 2.0 1.7

France 2.1 1.8 1.8 1.8

Italy 1.4 1.2 1.2 1.1

Spain 2.7 2.3 2.8 2.3

Japan 1.4 1.1 1.1 1.1

UK 1.5 1.5 1.3 1.5

Emerging Economies

Asia Pacific 5.8 5.7 5.9 5.7

China 6.6 6.4 6.6 6.4

India 7.4 7.6 7.4 7.5

Latin America 2.6 2.9 2.0 2.5

Brazil 2.7 3.0 1.7 2.6

Eastern Europe 3.2 2.9 3.2 2.8

Russia 2.0 1.9 1.8 1.8

Source: Consensus Forecasts.

2.2 Commodity Prices and Global Inflation The uptrend in the headline commodity index continued in the second quarter of the year and increased by 25.2 percent on a quarterly basis. In this period, all subcategories recorded an uptick while the increase in energy prices index surpassed the rise in the general price index. Accordingly, energy and industrial metal prices significantly increased by 38.6 percent and 21.4 percent while agricultural and precious metal prices rose by 4.8 percent and 3.1 percent, respectively (Chart 2.2.1).

Industrial metal prices, which remained on an uptrend in the first quarter of the year on the back of the positive outlook in global growth, followed a rather flat course in the second quarter due to risks fueled by the increased protectionism in foreign trade policies. In addition, tightened credit conditions and the relatively stagnant course of domestic demand are also believed to have affected these price movements despite China’s ongoing cutback on steel and aluminum production in line with its environmental policies implemented under a three-year program. Moreover, the withdrawal of the US from the nuclear deal with Iran and its announcement to place a new and more aggressive economic embargo on Iran reinforced the uptrend in prices brought about by the positive global growth outlook and the supply-demand balancing in the crude oil market in the first quarter. At the end of June, OPEC members abandoned their previous supply cut decision and announced that they would increase their oil production. However, the potential easing effect of this decision on prices remained limited due to the seasonal increase in demand during the summer months and the persistence of supply cuts in major oil producing countries driven by geopolitical factors. On the other hand, gold prices stuck to their flat course in the second quarter of the year due to the ongoing strong monetary policy normalization by advanced country central banks and the appreciating US dollar.


15

Chart 2.2.1: S&P Goldman Sachs Commodity Index (January 2014=100)

Chart 2.2.2: Brent Crude Oil Prices (USD/bbl)


*Denotes the arithmetic average of the prices quoted at futures contracts during 1-26 April 2018.

** Denotes the arithmetic average of the prices quoted at futures contracts during 1-26 July 2018.

The geopolitical turmoil in the Middle East is an upside risk factor for commodity prices. Meanwhile, increased protectionism in global foreign trade stands out as a downside risk factor for commodity prices due to its dampening effect on import demand and potential adverse effect on global growth. It is believed that in the upcoming period, the US shale oil production will be the determining factor in oil prices rather than the production decisions of OPEC. In a period when the crude oil market converged to a more balanced plateau, the moderation in the US shale oil production particularly due to infrastructure problems is also considered an additional upside risk factor in crude oil prices. Accordingly, as signaled by the Brent crude oil futures contracts, crude oil prices are expected to be trading around USD 75 at end-2018 (Chart 2.2.2).

The headline and core inflation rates in advanced and emerging economies have both increased slightly since the previous reporting period in line with rising commodity prices, but they nevertheless remained moderate (Chart 2.2.3 and Chart 2.2.4). Inflation forecasts for 2018 have been revised upwards for some advanced economies in the inter-reporting period (Table 2.2.1).

Chart 2.2.3: CPI Inflation in Advanced and Emerging Economies (Y-o-Y % Change)

Chart 2.2.4: Core Inflation in Advanced and Emerging Economies (Y-o-Y % Change)

Source: Bloomberg, CBRT. Source: Bloomberg, Datastream, CBRT.

30

50

70

90

110

130

02

.14

07

.14

12

.14

05

.15

10

.15

03

.16

08

.16

01

.17

06

.17

11

.17

04

.18

HeadlineEnergyIndustrial MetalsAgriculture

20

40

60

80

100

01

.15

10

.15

07

.16

04

.17

01

.18

10

.18

07

.19

Futures (July 26th)**

Futures (April 26th)*

Spot

-2

0

2

4

6

8

06

.10

06

.11

06

.12

06

.13

06

.14

06

.15

06

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06

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06

.18

Emerging Economies Advanced Economies

0

1

2

3

4

5

06

.10

06

.11

06

.12

06

.13

06

.14

06

.15

06

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06

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06

.18

Emerging Economies Advanced Economies


16

On the advanced economies front, low productivity rates in the US are believed to rein in the inflationary effect of the tight labor market implied by the unemployment rate. Despite survey- and market-based inflation expectations that hover around the 2-percent inflation target, recently rising oil prices have pushed the headline inflation slightly above the core inflation indicators. Inflation forecasts for the euro area based on futures oil prices indicate that consumer inflation is expected to be around 2 percent in 2018. In the medium-term, the ECB’s monetary policy steps, declining idle capacity, and accelerated wage increases are believed to moderately elevate core inflation indicators to the 2-percent level in the euro area. In Japan, both the headline and core inflation rates are below 2 percent, and inflation expectations do not display any change. On the other hand, in the UK, the depreciation of the sterling and rising oil prices prompted an upward revision in near-term forecasts for consumer and core inflation rates that hover above the 2-percent target.

Table 2.2.1: Inflation Forecasts for end-2018 and end-2019 (Annual Average % Change)

April July

2018 2019 2018 2019

Advanced Economies

USA 2.5 2.1 2.5 2.2

Euro Area 1.5 1.5 1.7 1.6

Germany 1.7 1.8 1.9 1.9

France 1.5 1.5 1.8 1.6

Italy 1.2 1.3 1.2 1.4

Spain 1.4 1.5 1.8 1.7

Greece* 0.7 1.2 0.8 1.1

UK 2.6 2.2 2.5 2.1

Japan 1.0 1.0 1.0 1.1

Emerging Economies

Asia Pacific (excl. Japan) 2.5 2.6 2.5 2.5

China 2.3 2.3 2.2 2.3

India** 4.8 4.8 4.9 4.8

Latin America 338.6 36.1 1653.7 383.3

Latin America (excl. Venezuela) 5.9 5.2 7.3 6.0

Brazil* 3.5 4.1 4.1 4.2

Eastern Europe 5.0 4.8 5.5 5.3

Russia* 3.7 4.0 3.6 4.1

Source: Consensus Forecasts.

* Annual percentage change.

** Based on fiscal year.

Upside risks to global inflation remain over the upcoming period. In the recent period, the US dollar has appreciated against many emerging market currencies. While the Fed’s balance sheet downsizing and rate hike processes continue, the increased borrowing need of the US Treasury due to accommodative fiscal policies dries up the global dollar liquidity. Under these circumstances, the probable persistence of depreciations in emerging market currencies and possible hikes in commodity prices, particularly in oil prices, amid geopolitical tensions in the Middle East may push global inflation up. Also, a US-imposed increase in tariffs on intermediate and consumer goods may accelerate consumer inflation in both the US and the counterparties in the medium term. The duration of this possible inflationary effect will be contingent on the degree of strict implementation of trade restrictions on a country and product basis.


17

2.3 Global Monetary Policy Decisions taken at Fed and ECB meetings in June indicate that the monetary policy normalization processes in the respective countries will be somewhat faster than anticipated. Although there was no deviation from the gradual tightening trend in general, the rate of the communicated tightening increased compared to the previous reporting period (Box 2.1). The Bloomberg expectations survey foresees a total of six rate hikes by the Fed in 2018 and 2019, and one rate hike by the ECB in the final quarter of 2019. The tightening in other advanced economies' monetary policies continued in line with the expectations. Accordingly, the central banks of Canada and Czechia further raised their policy rates by 25 basis points (Chart 2.3.1).

At its June meeting, the Fed introduced its second policy rate hike in 2018. In addition, the median of projections was revised to four rate hikes for 2018. In its press release, the Fed reinforced some of its statements on economic activity and the labor market, and signaled that the factors leading to rate hikes had become more evident. The Fed also decided to hold a press conference following each interest rate decision starting from 2019. In the current practice, the Fed holds a press conference for four of its eight interest rate decisions in a year, and although there is no such written rule, as a custom, it changes the interest rates only in months when a press conference takes place. So, through this change, the Fed, which is expected to introduce a maximum of four rate hikes a year, will be able to announce a change in rates after every meeting.

The ECB meeting in June clarified the policy normalization steps to be taken in the near future. At the same meeting, the ECB decided to reduce the monthly pace of the net asset purchases to 15 billion euros from 30 billion euros starting from October and end net purchases at the end of December. Moreover, the account of the meeting included a forward guidance statement that a rate hike was not expected before the summer of 2019. The upward revision in inflation forecasts and the emphasis on cost pressures through rising capacity utilization rates and wages indicate that the ECB has adopted a hawkish stance in the face of the recent sharp increase in inflation. Although these changes in monetary policy are aligned with market expectations, the rising inflation led the ECB to announce these decisions in June instead of suspending them until its August meeting. Yet, the ECB preserves its cautious stance due to the deceleration in growth.

Chart 2.3.1: Policy Rate Changes and Year-End Policy Rate Expectations in Advanced Economies January 2017 – December 2019* (Basis Point)

Chart 2.3.2: Policy Rate Changes and Year-End Policy Rate Expectations in Emerging Economies January 2017 – December 2019* (Basis Point)


* As of 27 July 2018. * As of 27 July 2018.

USA

Canada

Czechia

UK

Korea

Sweden

Norway

Australia

New Zealand

Israel

Euro Area

Japan

0

25

50

75

10

0

12

5

15

0

17

5

20

0

22

5

25

0

January 2018 - March 2018 April 2018 - July 2018

2018 End-year Forecast 2019 End-year Forecast

RomaniaPhilippines

PolandMexico

ThailandIndia

China

ChileIndonesia

S. AfricaPeru

ColombiaRussia

Brazil

-85

0

-75

0

-65

0

-55

0

-45

0

-35

0

-25

0

-15

0

-50

50

15

0

25

0January 2018 - March 2018 April 2018 - July 2018

2018 End-year Forecast 2019 End-year Forecast


18

For both the Fed and the ECB, the likely interest rate paths implied by their official statements and surveys significantly diverge from the interest rates priced in financial markets. In other words, these scenarios have not been fully priced on the market. Therefore, if the perception that inflation has definitively hit the medium-term target strengthens and the probability of a total of six rate hikes by the Fed and one rate hike by the ECB in the 2018-2019 period increases, these will probably be effective on financial markets and the risk appetite.

As for the monetary policy stance of emerging economies, there has been a relative tightening due to the uptrend in inflation and the tightened global financial conditions. Consequently, interest rate cuts lost pace, and central banks introduced rate hikes in Indonesia, India, and Mexico that were adversely affected by global financial conditions. Expectations signal a more pronounced tightening particularly in 2019 (Chart 2.3.2).

2.4 Global Risk Indicators and Portfolio Flows In the second quarter of 2018, increased protectionism in foreign trade affected global bond and stock markets. The possible downward effect of additional tariff steps, particularly by the US but also by China and the European Union, on global growth caused a rise in uncertainties surrounding central bank policies and increased the demand for safe assets, leading to a decline in bond yields (Chart 2.4.1). Moreover, increased expectations for a decrease in global trade volume and in the profitability of firms triggered rapid outflows from stock markets of emerging economies whereas stock markets of advanced economies remained almost flat (Chart 2.4.2).

Chart 2.4.1: 10-Year Bond Yields (%) Chart 2.4.2: MSCI Indices (January 2015=100)


The deterioration in risk perception caused by increased protectionist measures led to outflows from bond and stock markets of emerging economies, which in turn provoked sharp increases in exchange rate volatilities in these countries. However, the volatility in the currencies of advanced economies moderately increased (Chart 2.4.3).

-0.5

0.0

0.5

1.0

1.5

2.0

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3.5

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Germany United States

United Kingdom Japan

70

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90

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120

130

140

11

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03

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07

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03

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07

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03

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07

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03

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07

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MSCI - Emerging Economies

MSCI - Advanced Economies


19

Chart 2.4.3: JP Morgan FX Volatility Indices (Weekly) Chart 2.4.4: Weekly Fund Flows to Emerging Economies (Billion USD, 4-Week Cumulative)

Source: Bloomberg. Source: EPFR.

In the first quarter of the year, portfolio inflows to emerging economies continued, albeit less brisk than in early 2018. However, in the second quarter, the strengthening normalization process in monetary policies of advanced economies, consistently increasing protectionism in foreign trade, and the financial worsening in emerging economies with relatively more fragile macroeconomic fundamentals negatively affected portfolio flows to these countries. Accordingly, emerging economies saw portfolio outflows starting from early May (Chart 2.4.4). In this period, emerging economies diverged from each other in terms of portfolio flows, and portfolio movements in countries such as Argentina, Brazil, and South Africa that are relatively more fragile in financial and macroeconomic terms suffered more adverse effects. On the other hand, portfolio inflows to China, which is the foremost target of the protectionist measures of the US, exhibited a more favorable outlook than those in other emerging economies.

Table 2.4.1: Composition and Regional Distribution of Fund Flows to Emerging Economies (Quarterly, Billion USD)

Total

Portfolio Composition Regional Composition

Bond Funds

Stock Funds

Asia Europe Latin

America

Middle East and

Africa

2015 Q1 -8.6 1.9 -10.5 -8.1 2.2 -2.4 -0.2

Q2 -8.0 1.4 -9.4 -6.9 0.4 -2.0 0.4

Q3 -45.3 -16.5 -28.8 -23.8 -6.5 -10.8 -4.1

Q4 -22.3 -12.7 -9.6 -11.1 -3.0 -6.4 -1.9

2016 Q1 -4.5 -1.2 -1.6 -2.5 -1.4 -0.3 -0.3

Q2 -1.4 7.3 -8.7 -4.5 0.7 1.9 0.6

Q3 42.4 26.1 16.3 17.9 7.5 12.4 4.7

Q4 -17.4 -9.3 -8.1 -12.6 -0.8 -2.7 -1.3

2017 Q1 32.7 19.9 12.8 8.2 7.7 12.4 4.3

Q2 52.6 24.4 28.2 25.2 7.6 14.5 5.4

Q3 37.1 17.3 19.8 19.4 4.9 9.2 3.5

Q4 29.5 11.8 17.6 14.8 3.7 8.3 2.7

2018 Q1 57.9 12.0 46.0 34.1 6.5 12.0 5.3

Q2 -10.4 -10.4 0.0 -0.7 -4.3 -3.3 -2.1

Source: EPFR.

5

7

9

11

13

15

11

.14

03

.15

07

.15

11

.15

03

.16

07

.16

11

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03

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07

.17

11

.17

03

.18

07

.18

JPM VXY-EM JPM VXY G7

-50

-40

-30

-20

-10

0

10

20

30

40

11

.14

03

.15

07

.15

11

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03

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07

.16

11

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03

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07

.17

11

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03

.18

07

.18

Equity Funds Bond Funds


20

On a regional basis, all emerging economies registered portfolio outflows from both bond and stock markets in the second quarter of 2018, particularly evident starting from June (Table 2.4.1).

The expansion of the tightening in financial conditions of advanced economies over the near future, lingering geopolitical uncertainties, and possible adverse effects of increased protectionism in global trade signal that the current weak course in portfolio flows to emerging economies will continue in the upcoming period.


21

Box 2.1

Monetary Policy Normalization in Advanced Economies: Current Phase and Expectations The importance of the pace of monetary policy normalization in advanced economies in terms of the global growth outlook and global risk appetite has been underlined many times; and a faster-than-projected tightening was defined as a significant risk factor. Bond purchasing programs with negative or around-zero interest rates have constituted the monetary policy scheme in advanced economies for a long time. However, central banks embarked on gradual monetary policy normalization to expand the room for policy maneuvers and safeguard financial stability. The sustained level of inflation beneath the target challenged normalization at the beginning, yet figures that were more consistent with the targets particularly since the start of 2018 have given a push to normalization. The normalization process has evolved gradually up to now, but its impact on emerging economies (EEs) has recently become more evident.

Currently, the Fed, the ECB, the Bank of England, the Bank of Canada and the Czech National Bank continue to progress toward normalization. The Fed ended bond purchases, and embarked on policy-rate increases and balance sheet downsizing. The Bank of England also completed bond purchases and implemented the first policy rate increase. The ECB is cutting down on bond purchases and has announced that the bond purchasing program will be phased out by the end of the year. Not opting for bond purchases, the Bank of Canada and the Czech National Bank also initiated rate increases. In addition to the policy rate, shadow short-term rates that reflect the effects of non-traditional monetary policies are trending upwards (Chart 1). Moreover, the Fed’s balance sheet shrank and the growth rate of the ECB’s balance sheet lost pace following the reduction of bond purchases (Chart 2).

Chart 1: Shadow Policy Rates (%) Chart 2: Balance Sheet Size (August 2008=100)

Source: The Reserve Bank of New Zealand.

Last observation: June 2018. Source: Bloomberg. Last observation: June 2018.

June marks an important step for the Fed’s and the ECB’s decisions on the path to normalization. The ECB in particular conveyed clearer messages for the future. In fact, the rise in inflation trends of both economies invigorated the belief that central banks had attained a target-consistent inflation path permanently, which resulted in a more pronounced communication regarding the normalization process.

-10

-8

-6

-4

-2

0

2

4

03

.14

09

.14

03

.15

09

.15

03

.16

09

.16

03

.17

09

.17

03

.18

Fed ECB BoE

420

430

440

450

460

470

480

490

500

200

220

240

260

280

300

320

340

01

.16

07

.16

01

.17

07

.17

01

.18

ECB Fed


22

As expected, the Fed raised the policy rate by another 25 basis points, and median expectations for the policy rate rose by 25 basis points both for 2018 and 20191. The Fed announced press meetings to be held following every FOMC meeting within the year as of January 2019 and also signaled for more than four possible rate increases. Hinting at a tighter monetary policy, an attempt was made to soften these decisions through Chairman Powell’s statement that they would not react to an inflation shock which is not likely to be persistent as well as the emphasis on the risks of a faster-than-needed tightening.

The ECB kept its policy rate unchanged, but announced a decision for the future of the bond purchasing program following September. Accordingly, the ECB will reduce bond purchases by half in the October-December period to 15 billion euro and terminate bond purchasing at end-2018. Statements of forward guidance were kept intact as the principal payments from maturing securities purchased will be reinvested for an extended period after the end of net asset purchases (i.e. the balance sheet would not be downsized) and accommodative monetary policy would continue as long as it is needed. Meanwhile, the forward guidance for rate hikes was rendered clearer and it was stated that the policy rate was not projected to change until the summer of 2019. The table below summarizes “hawkish” and “dovish” elements in the announcements of both central banks.

Table 1: Decisions Taken in June Meetings of the Fed and the ECB

Hawkish Dovish

Fed

Policy-rate increase by 25 basis points

Increase in expected median policy rates by 25 basis points each for 2018 and 2019

Press meetings to be held following all meetings as of 2019

Strengthening of some expressions in announcements on economic activity, special consumption and the labor market

Omission of the expression from the announcement that the policy rate will remain below the long-term equilibrium for a while

Chairman Powell’s press announcement of no reaction to an inflation shock that is unlikely to be persistent and emphasis on the risks to a fast tightening

Preserving the expression that the monetary policy remains “accommodative” in the announcement (the minutes of the last meeting include debates over the omission or preservation of this sentence)

ECB

The announcement on tapering bond purchases following September and termination by the year-end

Rendering the policy-rate projection clearer and announcement of no expected change in rates until the summer of 2019

Raising inflation forecasts and emphasizing cost pressures ,capacity utilization ratios and wages

Keeping the policy rate unchanged

Maintaining expressions such as there is no ruling on balance sheet downsizing

1 In fact, this points out an additional rate increase in total for 2018 and 2019. The median expectation, which was 3+3 previously, became 4+3.

Moreover, it should be noted that these projections are median values. Median values went up due to a change in 1-2 members’ forecasts. Nevertheless, it will be more accurate to conclude that the FOMC members slightly tightened the monetary policy stance .


23

Given the decisions and projections of both central banks, together with the Bloomberg survey of expectations, two base scenarios appear. Possible scenarios can be summarized as four rate increases in total in 2018 (two more hikes in the rest of the year) and three hikes in 2019 by the Fed; and one rate hike in the last quarter of 2019 by the ECB. Meanwhile, rates implied by options point that these scenarios have not yet been completely priced by the market (Charts 3, 4 and 5).

Rates implied by options are below FOMC median value for the Fed, and projections of the Bloomberg survey for the ECB. In other words, a development such as an increase in the inflation trend to cause the above-mentioned scenarios to stand out or render these scenarios more likely has the potential to exert pressure on the emerging economies’ exchange rate and policy rates. On the other hand, if the expectation for a looser rate path compared to these scenarios comes to the fore, the outcome will be the exact opposite. The aim here is to emphasize that the market does not completely priced possible scenarios. For example, if the expectation for the Fed to implement a fourth rate hike in this year grows stronger, this may exert pressure on the exchange rate and interest rates. Against this background, the normalization process is believed to remain influential in emerging economies.

Chart 3: End-2018 Fed Funds Rate Mid-point (%)

Chart 4: End-2019 Fed Funds Rate Mid-point (%)

Chart 5: End-2019 ECB Main Refinancing Rate (%)

Source: Bloomberg. Last Observation: June 2018.

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24

Inflation Developments

25

3. Inflation Developments Following a flat course in the first quarter of the year, annual consumer inflation rose by 5.16 points and hit 15.39 percent in the second quarter (Chart 3.1). Inflation increased across subgroups, while the increase in the contributions particularly from the food, core goods and energy items stood out (Chart 3.2). In the second quarter, the Turkish lira depreciated by around 16 percent against the currency basket. Reaching 35 percent during the last one year, the weakening in the Turkish lira proved the main challenge to inflation prospects. Oil and commodity prices also trended upwards in this period. Food inflation recorded an upsurge due to unprocessed food prices as a result of the exchange rate developments and adverse supply conditions in some products. Core goods inflation increased owing to durable consumption goods, which exhibit high and relatively fast exchange rate pass-through, while the course of demand conditions fed into the upward outlook in the group's inflation. In addition to exchange rate effects, rise in international oil prices also affected the notable acceleration in energy inflation in this period. On the other hand, implementation of fixed prices introduced by the tax adjustment in fuel products (re-setting of lump sum special consumption tax amounts according to changes that may occur in domestic refinery outlet prices) curbed a worse portrait in energy inflation.1

After a robust course in the first quarter of 2018, economic activity slowed and settled on a trend of balancing. However, the impact of demand conditions on inflation continued to hover at inflationary levels in the second quarter, albeit with some deceleration. The ongoing brisk recovery in tourism weighs on inflationary pressures on items with strong links to this sector. Inflation expectations deteriorated significantly in this period, and high levels of inflation had further adverse impacts on items with strong indexation behavior, particularly prices of services. Real unit wages also increased year-on-year. Having posted high figures since the last quarter of 2016, producer inflation hit 23.71 percent, leading producer prices to create apparent cost pressures on consumer prices.

Chart 3.1: CPI and D Index (CPI Excluding Unprocessed Food and Alcohol-Tobacco, Y-o-Y % Change)

Chart 3.2: Contributions to Annual CPI (Percentage Points)


* Core Goods: Goods excluding food, energy, alcoholic beverages, tobacco and gold.

** Tobacco and Gold: alcoholic beverages, tobacco products and gold.

1 Similarly, tobacco products witnessed a reduction in the proportional SCT rate in contrast to a raise in lump sum SCT rate in July. On the back of this change, inflationary pressures stemming from the prices of tobacco products in the short term were contained. Related short and medium/long term gains are mentioned in Box 3.1.

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26

In sum, inflation soared in the second quarter of the year and this upsurge spread through subgroups. Both annual inflation and the underlying trend of core indicators saw a notable deterioration. Diffusion indices suggest a significant strengthening in the price-raising tendency of economic units. Current levels of inflation and inflation expectations continue to pose risks to pricing behaviors. The projection that the effect of aggregate demand conditions on inflation will continue to fade gradually is preserved. Nevertheless, cost pressures, which grew more apparent amid the recent depreciation in the Turkish lira and the possible secondary effects thereof have an adverse impact on inflation outlook.

3.1 Core Inflation Outlook Annual core goods inflation rose by 4.62 points to 18.55 percent in the second quarter of the year (Chart 3.1.1). This was led mainly by the cumulative exchange rate effects, while aggregate demand conditions also contributed to the increase in group’s inflation. The rise in inflation spread across subgroups, but it was more evident in durable consumption goods due to the high and fast exchange rate pass-through in this group (Chart 3.1.2).

Chart 3.1.1: Prices of Core Goods and Services (Annual % Change)

Chart 3.1.2: Core Goods Prices (Annual % Change)

Source: TURKSTAT. Source: TURKSTAT.

In the second quarter, prices of durable goods rose by 8.22 percent; while the group's annual inflation increased by 9.19 points to 25.27 percent (Chart 3.1.2). This is attributed to products with high import content such as automobiles and white goods that manifest cumulative exchange rate effects (Chart 3.1.3). In addition, demand conditions also fed into price hikes. Annual inflation in the clothing group inched up by 0.56 points to 11.30 percent in this period (Chart 3.1.2). In addition to the depreciation in the Turkish lira, the demand for clothing supported by the robust course of exports and tourism sectors are held responsible for this outcome. Core goods excluding durable goods and clothing also trended upwards in this period. The largest contributors to price hikes in this group were housing maintenance and repair equipment, personal care products, home textiles and spare parts and accessories of transport vehicles. All in all, recent developments in the exchange rate were manifest in core goods across sub-items, and the underlying trend of inflation gained a noticeable momentum (Chart 3.1.4).

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27

Table 3.1.1: Prices of Goods and Services (3-Month and Y-o-Y % Change)

2017 2018

II III IV Annual I II Annual

CPI 1.49 1.32 4.31 11.92 2.77 6.23 15.39

1.Goods 1.12 0.58 5.80 12.99 2.83 7.16 17.26

Energy -2.26 3.46 4.88 10.41 2.11 5.60 16.99

Food and Non-Alcoholic Beverages -0.39 -1.16 5.70 13.79 6.06 7.29 18.89

Unprocessed Food -2.95 -5.60 8.74 15.55 6.71 12.50 23.23

Processed Food 2.17 3.08 3.04 12.20 5.43 2.22 14.47

Core Goods 4.44 0.58 7.51 15.45 0.88 8.67 18.55

Clothing and Footwear 14.46 -5.90 13.17 11.51 -9.15 15.04 11.30

Durable Goods (excl. gold prices) 0.27 3.37 7.58 18.08 4.09 8.22 25.27

Furniture 1.71 3.88 7.30 10.49 7.35 5.46 26.19

Electrical and Non-electrical Appliances

-0.31 1.65 4.72 10.24 1.39 4.87 13.18

Automobile -0.29 4.32 10.27 27.30 4.39 11.11 33.43

Other Durable Goods 2.99 2.58 0.90 12.77 3.76 5.98 13.83

Core Goods excl. Clothing and Footwear

2.86 2.09 3.10 15.13 4.34 4.74 15.04

Alcoholic Beverages Tobacco Products and Gold

-0.18 0.82 1.18 5.96 1.37 3.15 6.66

2. Services 2.33 3.06 0.95 9.47 2.62 3.93 10.96

Rent 1.93 2.75 2.35 9.21 1.99 2.20 9.62

Restaurants and Hotels 2.90 3.84 1.65 11.47 2.81 4.40 13.30

Transport 3.41 4.20 0.44 12.46 1.18 4.48 10.64

Communication 0.85 0.54 0.12 1.87 -0.72 6.45 6.38

Other Services 2.14 2.93 0.17 9.39 4.45 3.51 11.47



28

Chart 3.1.3: Selected Durable Consumption Good Prices (Annual % Change)

Chart 3.1.4: Core Goods Prices (Seasonally-Adjusted, Annualized, 3-Month Average % Change)


Prices of services rose by 3.93 percent, and the group's annual inflation picked up by 1.70 points to 10.96 percent in the second quarter of the year (Chart 3.1.1). Annual inflation registered increases in all subgroups in this period (Chart 3.1.5).

Chart 3.1.5: Prices of Services by Sub-Categories (Annual % Change)

Chart 3.1.6: Accommodation Services and Tourism Revenues (Annual % Change)


The largest contribution to the rise in services inflation came from the communication group. Annual inflation in this group surged by 5.60 points to 6.38 percent due to prices of internet services. Annual inflation in restaurants-hotels, divided into two groups as catering and accommodation services, reached 13.30 percent in this period. This was led by hikes in food prices as well as the robust outlook for tourism. It was remarkable that annual inflation in accommodation services, which is closely related to the tourism sector, climbed by around 5 points to 15.67 percent (Chart 3.1.6). Inflation in transport services reached 10.64 percent in this period due to the depreciation in the Turkish lira, developments in oil prices and the favorable outlook in domestic tourism. On the other hand, implementation of fixed prices in fuel contained a worse outlook in the transport inflation. Manifesting lagged effects of the exchange rate and backward indexation behaviors, annual inflation in other services hit 11.47 percent, while rent inflation remained on the rise in this period.

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29

Chart 3.1.7: Other Services and Currency Basket* (Annual % Change)

Chart 3.1.8: Transport Services and Fuel Prices* (Annual % Change)


* Average Turkish lira against the euro and the US dollar.


* Inflation in transport services is backdated by 8 months.

Both the underlying trend of services inflation and the tendency to hike prices as captured by the diffusion index for services posted significant increases, signaling an apparent deterioration in the pricing behavior in the services sector (Charts 3.1.9 and 3.1.10). High inflation and inflation expectations, the weak course of the Turkish lira, worsening food inflation and brisk prospects for tourism caused services inflation to remain elevated. Moreover, rising real unit labor costs due to wage adjustments and low productivity, adversely affect the inflation outlook for the services sector due to its labor-intensive nature.

Chart 3.1.9: Services Prices (Seasonally-Adjusted, Annualized, 3-Month Average % Change)

Chart 3.1.10: Diffusion Index for Services Prices * (Seasonally-Adjusted, 3-Month Average)


* Diffusion index is calculated as the ratio of the number of items with increasing prices minus the number of items with decreasing prices to total number of items within a given month.

Among core inflation indicators, annual inflation in the B and C indices increased by 2.63 and 3.16 points quarter-on-quarter to 14.58 and 14.60 percent, respectively, owing to the developments in prices of core goods and services (Chart 3.1.11). The seasonally-adjusted underlying trend of core inflation indicators also recorded an evident deterioration in this period (Chart 3.1.12).

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Chart 3.1.11: B and C Indices (Annual % Change) Chart 3.1.12: B and C Indices (Seasonally-Adjusted, Annualized, 3-Month Average % Change)


The tendency for price hikes of economic units proved higher, as captured by the diffusion indices for core indicators (Chart 3.1.13). Both Median and SATRIM, the alternative core inflation indices monitored by the CBRT, registered sharp increases (Chart 3.1.14). Hence, as suggested by the indicators for tendency and pricing behavior, the underlying trend of inflation recorded a notable worsening.

Chart 3.1.13: B and C Diffusion Indices (Seasonally-Adjusted 3-Month Average)

Chart 3.1.14: Core Inflation Indicators SATRIM* and Median** (Annualized 3-Month Average, %)


* SATRIM: Seasonally-Adjusted trimmed mean inflation.

** Median: Seasonally-Adjusted median monthly inflation of 5-digit sub-price indices.

3.2 Food, Energy and Alcohol-Tobacco Prices Annual food inflation, which was 10.37 percent in March, went up by around 8.52 points to 18.89 percent in the second quarter (Chart 3.2.1). While this was largely caused by soaring unprocessed food prices, processed food prices remained elevated (Chart 3.2.2). The depreciation in the Turkish lira, negative supply conditions in some vegetable products, temporary effects led by Ramadan as well as tourism-driven demand conditions were influential in the course of food prices.

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SATRIM Median


31

After receding in the first quarter, annual unprocessed food inflation soared by 16.92 points to 23.23 percent in the second quarter due to exchange rate developments and negative supply conditions in certain products (Chart 3.2.2). Maintaining the downtrend of the first quarter also in April and coming down to quite low levels due mainly to the mild course in fresh fruits and vegetables, unprocessed food inflation witnessed notable upswings in May and June as the trend reversed in fresh fruits and vegetables (Chart 3.2.3). This period was marked by soaring prices of potato and egg as well as vegetables, particularly onion (Chart 3.2.4). In the first quarter of 2018, temperatures above seasonal averages favored the unprocessed food group, but following the rainless April, excessive rains in May harmed agricultural fields and had a negative impact on the supply of some vegetable products. The upcoming period is expected to witness a correction in prices of fresh fruits and vegetables amid the supply of new products.

Chart 3.2.3: Food Excl. Fresh Fruits and Vegetables (Annual % Change)

Chart 3.2.4: Selected Food Prices (Annual % Change)


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Chart 3.2.1: Food and Energy Prices (Annual % Change) Chart 3.2.2: Food Prices (Annual % Change)


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32

Annual processed food inflation, which reached quite high levels at the end of the first quarter, remained relatively flat in the second quarter with 14.47 percent (Chart 3.2.2). There exist upside risks on the future outlook for processed food prices stemming from bread-cereals and the possible consequences of the latest adjustment in the raw milk reference price. Accumulated cost pressures in raw milk prices, chiefly feed prices, have the potential to worsen processed food inflation through the dairy products channel. Moreover, owing to the rise in wheat purchasing prices, there are upside risks to the prices of the bread-cereals group, particularly bread. Energy prices increased by 5.60 percent in the second quarter of the year (Table 3.1.1). After ending the previous quarter at 66 USD/bbl, Brent crude oil prices trended upwards in the two subsequent months and hovered around 75 USD/bbl at the end of the second quarter. In tandem with the upward trajectory in the exchange rate, TL-denominated oil prices witnessed a remarkable increase in this period (Chart 3.2.5). Accordingly, fuel, bottled gas and solid fuel prices rose by 9.50, 4.54 and 3.85 percent, respectively in the second quarter. As of mid-May, a sliding scale tariff in fuel was introduced. Accordingly, lump sum special consumption taxes were re-adjusted according to the changes to occur in domestic refinery outlet prices due to international oil prices or the exchange rate, and as a result, fuel prices have remained flat as of mid-May. Thus, a worse picture in energy inflation was averted. In this period, out of administered prices, natural gas did not record a noticeable change, while prices of the municipal water, for which backward-indexation in inflation prevails, and the electricity prices increased by 3.55 and 2.90 percent, respectively (Chart 3.2.6). All in all, annual energy inflation climbed by 8.70 points to 16.99 percent in this quarter (Chart 3.2.1).

Chart 3.2.5: Oil and Selected Domestic Energy Prices* (Index, December 2010=100)

Chart 3.2.6: Domestic Energy Prices (Annual % Change)

* Oil price are reported in TL.

Source: Bloomberg, CBRT, TURKSTAT.

Source: TURKSTAT.

3.3 Domestic Producer Prices Led by the manufacturing industry and production and distribution prices of electricity and gas, domestic producer prices (D-PPI) spurted by 9.72 percent in the second quarter of the year (Table 3.3.1). Having notably accelerated as of the last quarter of 2017, producer price increases grew stronger in this period. Thus, annual D-PPI inflation surged by 9.43 percent quarter-on-quarter to 23.71 percent and hit the highest level of the index history (Chart 3.3.1). Developments in the exchange rate and international commodity prices, chiefly oil and metals, weighed on producer prices in this period. As a result, notable price increases were seen across subgroups.

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Table 3.3.1: D-PPI and Sub-Categories (3-Month and Y-o-Y % Change)

2017 2018

II III IV Annual I II Annual

D-PPI 1.35 1.82 5.18 15.47 5.29 9.72 23.71

Mining -2.60 1.85 6.88 16.13 6.52 7.02 24.09

Manufacturing 1.43 2.13 5.52 16.64 4.98 9.68 24.10

Manufacturing excl. Petroleum Products

1.76 1.86 5.04 16.16 5.01 9.04 22.51

Manufacturing

excl. Petroleum and Base Metal Products

2.03 1.08 4.21 14.04 4.88 8.58 19.96

Production and Distribution of Electricity and Gas

2.27 -2.37 -0.07 0.41 9.43 12.35 19.95

Water Supply 1.71 1.26 1.56 11.30 0.02 3.17 6.13

D-PPI by Main Industrial Groupings

Intermediate Goods 0.90 3.15 7.21 20.75 5.38 10.24 28.47

Durable Consumption Goods 3.47 2.02 3.47 16.31 3.57 6.69 16.64

Durable consumption goods (excl. jewelry)

3.91 2.07 2.91 15.89 3.53 6.56 15.88

Non-durable Consumption Goods 2.86 -0.88 1.00 7.69 4.32 7.61 12.39

Capital goods 1.27 3.07 6.26 17.52 5.81 8.39 25.60

Energy -1.36 1.73 6.59 11.23 7.61 15.58 34.87


Annual inflation hit 24.10 percent in the manufacturing industry and 28.47 percent in intermediate goods (Table 3.3.1 and Chart 3.3.2). In this period, import prices increased at a relatively moderate pace in USD terms, while the rise in TL terms proved quite notable due to the developments in the exchange rate (Chart 3.3.3).

Chart 3.3.1: Domestic Producer and Consumer Prices (Annual % Change)

Chart 3.3.2: Manufacturing Prices (Annual % Change)


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According to the main industrial groupings, price hikes prevailed in all subcategories in this quarter (Table 3.3.1). Prices of intermediate goods saw a widespread upsurge, particularly in iron-steel, plastics, threads and fibers, basic chemical products, textiles and paper products. Metal construction products, motor vehicles and spare parts and accessories, and machinery accounted for the price hikes in capital goods. Energy prices rose owing to petroleum products, production, transmission and distribution of electricity as well as manufacturing prices of gas. Increase in prices of durable consumption goods is attributed to furniture and home appliances while non-durable consumption goods saw price hikes owing to prices of meat and meat products, fats and oils, printing services and apparel. Against this background, the seasonally-adjusted underlying trend of manufacturing prices excluding petroleum and base metal products, which entails information on underlying trend of producer prices, gained considerable momentum (Chart 3.3.4). All in all, producer-driven cost pressures on consumer prices remained strong with a notable escalation.

Chart 3.3.3: Import Prices in USD and TL (Index, 2010=100)

Chart 3.3.4: Manufacturing Prices Excluding Petroleum and Base Metal Products (Seasonally Adjusted, Annualized, Q-o-Q % Change)


3.4 Agricultural Producer Prices Annual agricultural inflation (A-PPI) in the second quarter recorded an uptick by 1.27 points to 8.97 percent (Chart 3.4.1). Prices of vegetables stood out in this rise in annual inflation. In the second quarter, the uptrend in livestock prices continued, particularly in sheep and goats. Annual inflation increased in grains such as wheat and corn, while prices of fruit and legumes trended downwards. A-PPI and food consumer inflation displayed a noticeable divergence in this period (Chart 3.4.1). This divergence is more pronounced in the underlying trend indicators (Chart 3.4.2). The underlying trend of agricultural producer prices followed a favorable course in this quarter, whereas the trend of food consumer prices reached a considerably high level. For example, the gap between producer and consumer prices of onion and potato expanded severely in this period (Charts 3.4.3 and 3.4.4). This divergence in outlook for producer and consumer prices is attributed to market failures in storable products of this kind (Box 3.2).

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Chart 3.4.1: Prices of Agricultural Products and Food (Annual % Change)

Chart 3.4.2: Prices of Agricultural Products and Food (Seasonally Adjusted, Annualized, 3-month Average % Change)


Favorable supply outlook supported by weather conditions in the first quarter of 2018 had a downward pressure on agricultural prices. However, the ensuing period was marked by flood and hail, which restricted the supply of vegetables. Sharp price increases in vegetable products are expected to be partially compensated for by supply conditions, which are supposed to improve in the upcoming months.

Chart 3.4.3. Onion Prices (TL) Chart 3.4.4. Potato Prices (TL)


3.5 Expectations Following a relatively flat course in the first quarter of 2018, inflation expectations increased remarkably in the second quarter of the year amid cost shocks and the overall inflation outlook. As of July, expectations for the next 12 and 24 months hit 11.07 and 9.54 percent, respectively (Chart 3.5.1). 5-year and 10-year-ahead inflation expectations increased as well and continue to hover above the inflation target (Chart 3.5.1).

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36

Chart 3.5.1: CPI Inflation Expectations* (%) Chart 3.5.2: Medium-Term Inflation Expectations Curve* (%)


* Second survey period results for the pre-2013 period using the CBRT Survey of Expectations, responded by the representatives from the corporate sector, the financial sector and professionals.

* Calculated by linear interpolation of expectations for different time spans using the CBRT Survey of Expectations responded by the representatives from the corporate sector, the financial sector and professionals.

Inflation expectations were revised upwards quarter-on-quarter across all maturities, more markedly for the shorter term (Chart 3.5.2). In addition, the probability distribution of inflation expectations also exhibited a considerable deterioration compared to April (Charts 3.5.3 and 3.5.4). Deterioration in medium-term inflation expectations persists, posing upside risks to the inflation outlook through the pricing behavior.

Chart 3.5.3: Probability Distribution of 12-Month-Ahead Inflation Expectations* (%)

Chart 3.5.4: Probability Distribution of 24-Month-Ahead Inflation Expectations* (%)


* Horizontal axis denotes the expected inflation rate, while the vertical axis denotes the respective probability. For further details, see Statistics/Tendency Surveys/Survey of Expectations/Metadata at the CBRT website.

* Horizontal axis denotes the expected inflation rate, while the vertical axis denotes the respective probability. For further details, see Statistics/Tendency Surveys/Survey of Expectations/Metadata at the CBRT website.

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37

Box 3.1

Tax Change in Tobacco Products and Its Repercussions on Inflation In July 2018, tax rates applied to tobacco products were changed. This change constituted a step towards convergence of our tax structure to international averages. Moreover, significant gains were achieved in enhancing the coordination between monetary and fiscal policies in the struggle with inflation.

Differing from the general practice in products subject to Special Consumption Tax (SCT), the tax base employed to calculate the SCT on tobacco products is the final retail sales price of the product. This method reveals a relatively complicated taxation structure.1 The final sales price in tobacco products (Y) is composed of the sum of the producer price (X), the dealer-distributor (retailer-wholesaler) share and the ad valorem and specific SCT and VAT amounts (Table 1).

Table 1: Price Setting Mechanism in Tobacco Products

Final Sales Price: 𝒀

Producer Price: 𝑋

Dealer/Distributor Income (p= dealer-distributor share, %):

𝑌 ∗ 𝑝

Ad Valorem SCT Amount (SCT= ad valorem SCT rate, %):

𝑌 ∗ 𝑆𝐶𝑇

Specific SCT Amount per Packet: 𝑀

Total SCT Amount: (𝑌 ∗ 𝑆𝐶𝑇) + 𝑀

VAT Amount (vat= VAT rate, %): [𝑋 + (𝑌 ∗ 𝑝) + ( 𝑌 ∗ 𝑆𝐶𝑇) + 𝑀] ∗ 𝑣𝑎𝑡

Final Sales Price = Producer Price+ Dealer/Distributor Income+ SCT Amount+ VAT Amount

𝑌 = 𝑋 + (𝑌 ∗ 𝑝) + [(𝑌 ∗ 𝑆𝐶𝑇) + 𝑀] + [𝑋 + ( 𝑌 ∗ 𝑝) + (𝑌 ∗ 𝑆𝐶𝑇) + 𝑀] ∗ 𝑣𝑎𝑡

𝑌 = (1 + 𝑣𝑎𝑡) ∗ (𝑋 + 𝑀)

1 − (1 + 𝑣𝑎𝑡) ∗ 𝑆𝐶𝑇 − (1 + 𝑣𝑎𝑡) ∗ 𝑝

Source: Atuk and Özmen (2016).

Price formation reveals that final sales price is non-linearly related to the VAT rate, the SCT rate and the dealer-distributor share; and as the level is elevated in these tax rates, a one-unit increase has a higher outcome on final prices (multiplier effect). The current tax structure relies mostly on ad valorem tax, and the ad valorem SCT rate, which is 65.25 percent in the first half of 2018, is significantly higher than the European Union average of 27 percent (Chart 1). Moreover, in comparison with the EU-28, the highest ad valorem SCT rate proved to be exerted in Turkey even after the revision introduced in July (Chart 2).

As the ad valorem SCT rate decreases, the multiplier effect declines as well (Chart 3). Prior to the recent tax change, the multiplier was around 8, implying that a 10-kurus increase in producer or specific SCT amount reflects on the final sales price as around 80 kurus. In other words, the high

1 For chronological development and further information on the subject, see Atuk, Çebi, Özmen (2011), CBRT (2013), Atuk and Özmen (2016).


38

multiplier renders a small increment in the specific tax amount or the producer price to have a higher impact on the final sales price.

Chart 1: Comparison of Ad Valorem SCT Rates: Turkey and the European Union (%)

Chart 2: Ad Valorem SCT rates in EU-28 (%)

Source: EU Commission (2018). Source: EU Commission (2018).

Owing to the enhanced coordination between monetary and fiscal policies regarding administered prices and tax adjustments, the ad valorem SCT rate was reduced from 65.25 percent to 63 percent, and the specific SCT amount per packet was raised from 32.46 kurus to 42 kurus in July. This not only curbed short-term inflationary pressures, but also allowed the multiplier to recede to 6.8 from 8 (Chart 3). Thus, in the period ahead, the impact of a potential increase in producer prices or specific taxes on inflation is also restricted. Comparison with the EU countries signals that there is long way to go in this respect and this arrangement constitutes a starting point in harmonization with the internationally-exercised taxation.

Chart 3: Ad Valorem SCT Rate (%) and Multiplier

Source: CBRT Estimates.

As a result, from a medium/long term perspective, reducing the weight of the ad valorem tax within the final sales prices while increasing the share of the specific tax mitigates the impact of the multiplier effect of tax and producer price adjustments on final sales prices and gains importance in the convergence with EU averages. In this respect, this arrangement constitutes an example of an enhanced coordination between monetary and fiscal policies. In the meantime, a stronger coordination in areas other than administered prices and tax adjustments will also offer valuable contribution to the struggle for disinflation in the upcoming period.

65.2563.00

52.00

27.11

1.000

10

20

30

40

50

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70

Turk

ey (

Jun

e.1

8)

Turk

ey (

July

.18

)

EU-2

8 H

igh

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8 A

vera

ge

EU-2

8 L

ow

est

63.0

52.051.0

46.7

39.0

34.030.0

26.025.0

23.422.6

20.015.0

9.0

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30

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50

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70

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RO NL

SE

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39

References

Atuk, O. Çebi, C. and Özmen, M. U. (2011), “Special Consumption Tax on Tobacco Products”, CBRT Research Notes in Economics No. 11/16.

Atuk, O. and Özmen, M.U. (2016), “Firm Strategy and Consumer Behavior under a Complex Tobacco Tax System: Implications for the Effectiveness of Taxation on Tobacco Control”, Tobacco Control, 26(3), 277-283.

CBRT (2013), “Recent Changes to Taxing of Tobacco Products and the Effects of SCT Rate Hikes on Prices”, 2013-I inflation Report, Box 3.1.

European Commission (2018), “Excise Duty Tables, Part III-Manufactured Tobacco”, Directorate-General Taxation and Customs Union.


40

Box 3.2

Structural Problems in Unprocessed Food Inflation and Policy Recommendations Driven by fresh vegetable products, the unprocessed food group stood out as the highest contributor to consumer inflation in the first half of 2018. Following a favorable outlook in the first quarter of 2018, unprocessed food prices increased well above seasonal averages in the second quarter due particularly to the notable acceleration in fresh vegetable prices (Table 1). The upsurge in fresh vegetable prices in the second quarter of the year is attributable to meteorological factors such as excessive rain, flood, and hail as well as production losses in various products such as potato and tomato due to diseases in plants.

The conjunctural reasons underlying the price hikes in unprocessed food products are evaluated from the perspective of structural problems, and policy measures that may solve structural problems are discussed in this box. In this respect, the structural problems that stand out are: cyclical supply shortages, stocking and price speculation behaviors, the excess number of intermediaries in the supply chain and underdeveloped logistic processes.

Table 1: Annual Inflation Across Product Groups (%)

Product Groups March 2018

June 2018 2013-2017 March

Averages 2013-2017 June Averages

Food and Non-alcoholic Beverages

10,37 18,89 9,89 11,12

Processed food 14,42 14,47 9,15 9,29

Unprocessed Food 6,31 23,23 10,61 13,47

Fresh Vegetable -2,29 83,58 11,96 14,20

Fresh Fruit 4,79 4,15 12,06 17,40

Source: TURKSTAT.

In the second quarter of 2018, the sharp acceleration in unprocessed food prices is mainly attributable to the cyclical supply shortage in various fresh vegetable products. Occasional supply shortages in unprocessed food products in Turkey that lead to sudden and sharp price increases mainly stem from structural factors. Here, the inability to make an efficient and dynamic agricultural production plan is considered to be a significant structural problem. Developing a production plan requires strengthening of agricultural statistics, yield estimation and early warning system infrastructure. Accordingly, expanding the scope of agricultural statistics and enhancing their quality is of great importance. Moreover, establishing a systematic structure to facilitate a dynamic follow-up and estimation of agricultural yields will also contribute to the timely adoption of measures required to maintain sustainability of supply and price stability. Another structural problem causing cyclical supply shortages is the mismanagement of the field-greenhouse-field transition particularly in fresh vegetable products. Despite being short-lived, these transitions lead to supply shortages and enable the intermediaries who dominate the market to speculate on prices and achieve excessive gains. A holistic approach needs to be developed and enforced to ensure sustainable supply in field-greenhouse and greenhouse-field transition processes. Accordingly, rehabilitation of current greenhouses and encouraging the establishment of new and modern greenhouses is a priority.


41

In Turkey, occasional market failures may occur in the process of warehousing storable fresh fruits and vegetables like potato, lemon, onion and apple, and including these products in the supply chain. These market failures can lead to sudden and sharp price increases in the respective product particularly in periods of supply shortages. Accordingly, the importance of efficient functioning of licensed warehousing and a specialized commodity exchanges system needs to be underlined. This system allows for the storage of agricultural products such as grains and legumes that can be standardized and stored for a long time as well as trading them in a deep market. Licensed warehousing facilitates the access of the producer to financing, reduces unregistered activities, lays the ground for putting the product on the market in a proper balance in terms of timing and quantity, and thus contributes to a healthy and stable price formation in storable food products market (Songül ve Tümen, 2017). Moreover, arranging natural warehouses, in which products like potato and onions are stored, and registering warehousing activities are also of critical importance to avert market-distorting collective movements.

Another structural problem regarding unprocessed food products in Turkey is the excess number of intermediaries in the supply chain and logistic processes that lag behind the practices of advanced economies. In many advanced economies, production, distribution and marketing of food is mainly performed by producer unions, while the share of producer unions within the supply chain is rather limited in our country. Most of the functions regarding marketing such as the provision, transfer, preservation, packaging and classification of agricultural products in Turkey are undertaken by intermediaries. On the one hand, this increases the dependence of producers on intermediaries. On the other hand, it raises the final consumer price and distorts price stability by causing the marketing channels to get longer, costs to elevate and the share of marketing to increase (Songül, 2017). Meanwhile, small farmers being mostly indebted to the tradesmen and other intermediaries and being able to maintain agricultural activities through this unregistered indebtedness deprives the farmer of the deserved share from the agricultural value added. This deters production and exerts an upward pressure on prices.

Modernization of wholesale markets is of critical importance with regard to the improvement of logistic processes in the supply chains of unprocessed food. The 175 wholesale markets operating under impractical conditions in our country render the market structure shallow and fragmented. The current wholesale market management model and ownership structure relying on municipal management leads to imperfect competition. Moreover, current locations of wholesale markets (transport, logistics, technology etc.) are not suitable for changing infrastructural conditions and may fail to ensure efficient distribution between production and consumption points. In short, when the current status is compared to international standards and good practices, there are aspects to be improved in productivity and efficiency. As a result of all these, healthy and stable price formation cannot be ensured in unprocessed food products, and control and inspection services for food safety cannot be performed properly.

With a view to modernizing logistic processes in the supply chain of fresh fruit and vegetable products in Turkey, the communique on principles and procedures on standard practices to be obeyed in wholesale and retail trade of vegetables and fruits was published in 2017. According to this communique, new standards were set regarding fruit and vegetable products post-harvest packing with disposable and reusable packages compliant with international norms, transporting them by vehicles with cooling systems to enhance transportation, and displaying them on aisles with coolers in retail sales points. However, some lags are witnessed in practice.


42

As a result, although occasional, sudden and sharp price increases in unprocessed food products are considered to be natural consequences of meteorological and phenological factors, mainly structural problems are important in the production and storage of unprocessed food products as well as the supply chain. It is believed that the adverse impacts of meteorological and phenological factors on the prices of unprocessed food products can be minimized by efficient and dynamic production planning, arranging storage activities, modernizing logistic processes in the supply chain and reducing the number of intermediaries.

References

Songül, H. and Tümen, S. (2017). How Does the Licensed Warehousing System Contribute to Price Stability? CBRT Blog Post.

Songül, H. (2017). Price Formation in the Fresh Fruit-Vegetable Supply Chain CBRT Blog Post.

Supply and Demand Developments

43

4. Supply and Demand Developments In the first quarter of the year, economic activity remained strong. Domestic demand, particularly private consumption, was the main driver of quarterly growth. Investments had a rather moderate contribution to growth due to weakened machinery-equipment investments. On the foreign demand side, exports and imports of goods and services both declined quarter-on-quarter but net exports nevertheless positively contributed to quarterly growth as the decline in imports was sharper.

Second-quarter indicators suggest that economic activity lost pace, entered a rebalancing process, and started converging to its underlying trend. The depreciation of the Turkish lira, the tightening in financial conditions, and perceptions of uncertainty are projected to rein in domestic demand in the second quarter through private consumption and investment channels whereas the accommodative stance of the public sector is expected to partially limit this slowdown. On the other hand, net exports continue to support growth with the contribution of the robust recovery in tourism. However, the persistently high levels of financial volatility and perceptions of uncertainty keep the downside risks to the magnitude and duration of the slowdown in economic activity alive.

4.1 Supply Developments In the first quarter of 2018, Gross Domestic Product (GDP) grew by 7.4 percent year-on-year and by 2.0 percent quarter-on-quarter in seasonally and calendar-adjusted terms. This GDP growth indicates that economic activity remains strong, even a little stronger than projected. On the production side, all subcategories had an upward effect on the year-on-year growth in the first quarter (Chart 4.1.1). In this period, in addition to strong domestic demand, industrial sector and services sector value added posted a large quarter-on-quarter increase, the increase in the latter one driven by the recovery in tourism, whereas the quarterly increase in construction sector and agricultural sector value added remained rather limited (Chart 4.1.2).

Chart 4.1.1: Contributions to Y-o-Y GDP Growth from the Production Side (% Point)

Chart 4.1.2: Contributions to Quarterly GDP Growth from the Production Side (Seasonally Adjusted, % Point)


Production indices signal a slowdown in economic activity in the second quarter. This slowdown has spread across all major sectors constituting GDP due to the volatility in financial markets and the consequently increasing perception of uncertainty. In the April-May period, industrial production slightly increased compared to the first quarter (Chart 4.1.3). During the same period, production increases in exporting sectors continued whereas domestically-oriented sectors, particularly sectors closely affiliated to construction, experienced a deceleration. Survey indicators suggest a June outlook that is similar to

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44

May outlook (Chart 4.1.4). Accordingly, the deceleration in the second quarter is projected to be probably stronger than implied by April-May data.

Considering the decrease in the production of construction-affiliated sectors together with the falling employment rates in the construction sector in April, it is envisaged that the construction sector value added will contribute less to growth in the second quarter relative to previous periods (Chart 4.1.5, Chart 4.3.4).

Chart 4.1.3: Industrial Production Index (Seasonally Adjusted, Quarterly % Change)

Chart 4.1.4: PMI and PMI Production (Seasonally Adjusted, Level)

Source: TURKSTAT. Source: IHS Markit. * As of the April-May period.

Services sector indicators hint at a slowdown in sectoral value added similar to the case in industrial and construction sectors (Chart 4.1.6). It is judged that in this period there was weakening in financial services due to sluggish loan utilization as well as in industry-related services subcategories. On the other hand, the favorable outlook in tourism-related subcategories is expected to continue on the back of the robust recovery in tourism. The pickup in employment in these sectors also confirms this evaluation (Chart 4.3.6).

Chart 4.1.5: Construction Sector Value Added and Composite Index** (Y-o-Y % Change)

Chart 4.1.6: Services Sector Activity and Value Added*

Source: TURKSTAT. * As of May. ** Construction sector composite index is measured by the annual percentage change in domestic real revenues in fabricated metals and mineral products. Weights are obtained from linear regression.

Source: TURKSTAT. * Services sector activity is measured by the question on services sector activity (in the last 3 months) under sectoral confidence indices.

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Services Sector Activity (seasonally adj., past 3 months, left axis)


45

4.2 Demand Developments An analysis of 2018Q1 data in terms of expenditures reveals that year-on-year and quarter-on-quarter growth were both driven by domestic demand (Chart 4.2.1 and Chart 4.2.2). In this quarter, private consumption sharply increased year-on-year and quarter-on-quarter due to the improvement in the labor market while public consumption provided a rather moderate contribution to growth. Investments had a construction-driven positive effect on quarterly growth whereas machinery-equipment investments dropped compared to the previous quarter. Exports registered no significant year-on-year change while imports of goods and services substantially increased. Accordingly, net exports weighed on annual growth. In quarterly terms, exports and imports of goods and services both slackened. However, since the fall in imports was more salient than the fall in exports, net exports had an upward effect on quarterly growth. The ongoing strong performance of gold imports contained the contribution of net exports to growth.

Chart 4.2.1: Contributions to Y-o-Y Growth from the Expenditure Side (% Point)

Chart 4.2.2: Contributions to Quarterly GDP Growth from the Expenditure Side (% Point)

Source: CBRT, TURKSTAT. Source: CBRT, TURKSTAT. * Change in inventories denotes inventories and statistical discrepancy due to the use of chain-linked index.

* Change in inventories denotes inventories and statistical discrepancy due to the use of chain-linked index.

Indicators for the second quarter suggest a rebalancing in economic activity. The depreciation of the Turkish lira, the increase in financial volatility, the rise in perceptions of uncertainty and financing costs, and the uptrend in inflation are anticipated to put a brake on domestic demand through consumption and investment expenditures channels. Yet, this deceleration in domestic demand is expected to be partially offset by the accommodative stance of the public sector that supports economic activity through expenditures and other fiscal measures. On the other hand, the positive contribution of net exports to growth continues as a result of the ongoing robust recovery in tourism and the downtrend in import demand triggered by the slowdown in domestic demand.

Indicators point to a deceleration in private consumption demand in the second quarter (Chart 4.2.3). This deceleration is attributed to price hikes caused by the depreciation in the Turkish lira, the fall in consumer confidence, and the increase in loan rates. As a matter of fact, the weakening is more pronounced in durable goods consumption which is intensely affected by these factors (Chart 4.2.4). On the other hand, the improvement in the labor market due to employment increases and the robust recovery in tourism have created a more favorable outlook in non-durable goods consumption. Nevertheless, as of the April period, non-durable goods consumption also lost pace quarter-on-quarter due to the interrupted uptrend in non-farm employment in the second quarter.

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Private Consumption GDP

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2014 2015 2016 2017 18

Change in Inventories* Net ExportsInvestments Public ConsumptionPrivate Consumption GDP


46

Chart 4.2.3: Private Consumption and Composite Indicator for Private Consumption** (Y-o-Y % Change)

Chart 4.2.4: Automobile and White Goods Sales (Seasonally Adjusted, Average, Thousand)

Source: ODD, CBRT, TURKSTAT, TURKBESD. Source: ODD, CBRT, TURKBESD. * As of May. ** The Composite indicator is the weighted average of the annual percentage changes in real turnover in non-durable goods, durable goods import quantity index, automobile sales, and retail sales volume index. Weights are obtained from linear regression.

Leading indicators of investment expenditures signal a more visible downturn in the second quarter compared to consumption (Chart 4.2.5). Financial volatility-driven perceptions of uncertainty and tightening financial conditions are believed to be the main factors curbing investments. The fall in investments is projected to become widespread, and machinery-equipment investments are anticipated to be more sluggish than construction investments. On the other hand, investment tendencies of export-oriented sectors remain stronger than those of other sectors despite a slight fall over the previous quarter (Chart 4.2.6).

Chart 4.2.5: Investment Expenditures and Composite Indicator for Investment Expenditures** (Y-o-Y % Change)

Chart 4.2.6: Fixed Capital Investment Tendency by Sectors Based on BTS (Seasonally Adjusted, Up – Down, %)

Source: CBRT, TURKSTAT. *As of May

Source: CBRT.

** The composite indicator for investment expenditures is the average of the annual percentage changes in production of capital goods, production and imports of non-metallic mineral products as well as commercial vehicle sales, housing sales, construction sector orders, commercial loan rate and FX-denominated loans, and capacity utilization rate series (manufacturing, services, trade, construction).

* As of July.

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Private Consumption

Composite Indicator for Private Consumption

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White Good Sales (left axis) Automobile

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Investment Expenditures

Indicators of Investment Expenditures

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2010 2011 2012 2013 2014 2015 2016 2017 18

Others Exporters


47

The boosting effect of net exports on quarterly growth is expected to continue in the second quarter. Strong foreign demand, supportive course of the real exchange rate, and foreign market diversification flexibility continue to affect exports of goods positively. Meanwhile, the depreciation of the Turkish lira and the slowdown in domestic demand have pulled import demand down (Chart 4.2.7). On the other hand, the persistence of the robust recovery in tourism reinforces exports via the services revenues channel (Chart 4.2.8). Exports of goods and services are expected to sustain their strong support to growth and favorably affect the current account balance in the upcoming period.

Chart 4.2.7: Quantity Indices for Imports and Exports (Excl. Gold, Seasonally Adjusted, 2010=100)

Chart 4.2.8: Tourism and Services Revenues (Real, Seasonally Adjusted, 2010=100)

Source: CBRT, TURKSTAT. Source: CBRT, TURKSTAT. * Forecast for June. * Forecast for June.

To sum up, while growth in the first quarter of 2018 proved a little stronger than projected, second-quarter data suggest that economic activity is slowing down and converging to its underlying trend. Yet, the ongoing robust recovery in tourism and the accommodative stance of the public sector are expected to partially contain this slowdown. However, the persistently high levels of financial volatility and perceptions of uncertainty keep the downside risks to the magnitude and duration of the slowdown in economic activity alive.

4.3 Labor Market The downtrend in unemployment rates continued from 2017 through the first quarter of 2018. In the first quarter, seasonally adjusted total and non-farm unemployment rates dropped quarter-on-quarter by 0.2 and 0.4 points to 9.9 percent and 11.7 percent, respectively (Chart 4.3.1). Thus, based on raw data, the year-on-year decrease was 2.0 points in total unemployment and 2.4 points in non-farm employment. This was due to the lack of any major change in the labor force participation rate despite the employment increases across all sectors compared to the previous quarter (Chart 4.3.2). In the April period covering March, April and May, the uptrend in employment and the downtrend in unemployment rates halted, and seasonally adjusted total and non-farm unemployment rates rose quarter-on-quarter by 0.4 and 0.5 points to 10.3 percent and 12.2 percent, respectively.

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Chart 4.3.1: Unemployment and Labor Force Participation Rates (Seasonally Adjusted, %)

Chart 4.3.2: Contributions to Quarterly Changes in Non-Farm Unemployment (Seasonally Adjusted, % Point)

Source: TURKSTAT. Source: TURKSTAT. * As of the April period. * As of the April period.

In the first quarter of 2018, approximately 1.2 million new people became employed compared to the same period last year. Non-farm employment received the largest contribution from the industrial sector in this quarter (Chart 4.3.3 and Chart 4.3.4). The sectoral employment outlook is consistent with the strong performance of sectors providing input for the construction sector and the overall manufacturing industry in the first quarter. The robust course of industrial production has also significantly affected employment in the sector, particularly since the second half of 2017. Sectoral diffusion of the manufacturing industry growth accompanied by the pickup in relatively more labor-intensive sectors are believed to be influential in this development (Chart 4.3.5). In the April period, construction sector employment slumped quarter-on-quarter whereas employment in services and industrial sectors moderately increased. This slowdown in employment is consistent with the rebalancing process in economic activity.

Chart 4.3.3: Non-Farm and Services Employment (Seasonally Adjusted, Million People)

Chart 4.3.4: Industrial and Construction Employment (Seasonally Adjusted, Million People)

Source: TURKSTAT. Source: TURKSTAT. * As of the April period. * As of the April period.

The services sector employment, which has been feeble since early 2018, slightly rose from the first quarter to the April period. In its subsectors, different trends are noted. The sound recovery in tourism in 2018 positively affects accommodation and catering services employment. Meanwhile, the impact of the accommodative stance of the public sector has become visible in employment in public administration

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and defense sectors as well as in human health and social services sectors. In addition, employment in the construction-affiliated real estate sector has been steadily increasing (Chart 4.3.6).

Chart 4.3.5: BTS Employment Expectation by Sectors for the Next 3 Months (Up-Down, Seasonally Adjusted, %)

Chart 4.3.6: Employment in Selected Services Subsectors (Seasonally Adjusted, Million People)

Source: BTS, CBRT. Source: CBRT, TURKSTAT. * As of July. ** Construction-affiliated sectors include rubber and plastics, minerals, basic metal and fabricated metal.

* As of the April period.

*** Labor-intensive sectors include textile, clothing, leather and furniture.

A breakdown of services subsectors by tradable and non-tradable also reveals different trends. Employment in wholesale-retail trade and transport-storage sectors keeps steadily increasing in conformity with the foreign trade outlook. Alternatively, employment in relatively closed services subsectors displays an outlook that is consistent with the deceleration in domestic demand (Chart 4.3.7).1

Chart 4.3.7: Employment in Selected Services Subsectors (Seasonally Adjusted, Million People)

Chart 4.3.8: PMI and Manufacturing Industry Employment (Seasonally Adjusted)

Source: TURKSTAT. Source: IHS Markit, TURKSTAT.

* As of the April period.

1 Tradable sectors include wholesale and retail trade, repair of motor land vehicles and motorcycles, and transport and storage subsectors while non-

tradable sectors include public administration and defense, real estate activities, information and communication, financial and insurance activities, professional, scientific and technical activities, administrative and support service activities, educational, cultural, artistic, entertainment, recreational, sport and other services activities, activities of households as employers, goods and manufacturing activities of households that are not earmarked for their own use, and activities of international organizations and agencies.

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Leading indicators for the labor market signal a sustained deceleration in employment, and it is notable that this outlook prevails across all sectors. In the second quarter of 2018, the PMI employment hit the lowest level since the second quarter of 2009, which indicates that the manufacturing sector employment may significantly weaken in the upcoming period (Chart 4.3.8). Employment expectations for the next 3-month period reveal that employment expectations have also deteriorated in the services subsectors (Chart 4.3.9). Data from Kariyer.net indicate that the total number of job applications increases faster than the total number of job posts. Consequently, the number of applications per job post, a measure that moves close to the unemployment rate, started increasing in the second quarter (Chart 4.3.10). In this context, it is projected that employment opportunities will be subdued in the upcoming period and unemployment rates will keep increasing after the April period.

Chart 4.3.9: Expected Number of Employees by Sectors for the Next 3 Months (Seasonally Adjusted)

Chart 4.3.10: Total Number of Job Posts, Applications per Job Post, and Non-Farm Unemployment Rate (Seasonally Adjusted)

Source: CBRT, TURKSTAT. Source: Kariyer.net, CBRT. * As of July. * Non-farm unemployment rate is as of the April period.

4.4 Wages and Productivity In the first quarter of 2018, the growth rate of wages accelerated (Chart 4.4.1). The 14.2-percent raise in the minimum wage in 2018 has also elevated other wages. In this period, the annual rate of increase in non-farm nominal gross wage and earnings index stood at 20.7 percent while the average annual rate of increase in consumer inflation was 10.3 percent. This led to a substantial rise in real wages in the first quarter of 2018. Meanwhile, the partial labor productivity growth in the non-farm sector limited real unit labor costs. In the first quarter of 2018, the value-added-based partial labor productivity (value added as a ratio of employment) and real wage per person surged year-on-year by 1.6 percent and 2.9 percent, respectively (Chart 4.4.2). Accordingly, real unit wages (real wage per person/productivity) rose.

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Chart 4.4.1: Non-Farm Nominal Earnings Index and Net Minimum Wage (Nominal, 2015=100, Y-o-Y % Change)

Chart 4.4.2: Non-Farm Partial Labor Productivity*, Per Person Real Wage and Real Unit Wage** (2015=100, Y-o-Y % Change)

Source: CBRT, TURKSTAT. Source: CBRT, TURKSTAT. * Non-farm value added/non-farm employment (HLS).

** Real wage per person * employment/value added.

In the first quarter of 2018, the rate of increase in the real earnings index accelerated (Chart 4.4.3). This acceleration was observed in all non-farm sectors. Likewise, the real minimum wage also increased in the same period. The nominal hourly labor cost index registered a high rate of increase of 5.9 percent in seasonally adjusted terms. However, rises in partial labor productivity restrained the increases in real unit labor costs in all sectors (Chart 4.4.4).

Chart 4.4.3: Non-Farm Hourly Earnings Index (Seasonally Adjusted, 2015=100)

Chart 4.4.4: Real* Unit Labor Cost by Sectors** (2015=100, Y-o-Y % Change)


* Deflated by CPI. * Deflated by CPI.

** Real labor cost/productivity (value added/HLS employment).

In addition to minimum wage developments, the course of economic activity, the unemployment rate, and inflation developments also play a decisive role in wages. Even though the upward pressure of economic activity and unemployment developments on wage inflation will abate from the second quarter onwards, elevated levels of inflation will continue to affect wages through the indexation channel. Under this outlook, nominal wage hikes are projected to hover above the average of previous years throughout 2018. Therefore, sustaining productivity increases in the period ahead is important to contain real unit labor cost pressures.

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4.5 Output Gap To assess the cyclicality of the economy and the demand-driven pressures on inflation, output gap indicators derived via various methods are monitored at the CBRT.2 It is noted in the previous sections of the report that economic activity slowed and started converging to its underlying trend in the second quarter. Accordingly, output gap indicators also signal a rebalancing in the economy following the peak in the first quarter (Chart 4.5.1). However, although each one of the indicators of the output gap, which is an unobservable variable, intrinsically includes a forecast uncertainty, there is a consensus that the positive levels were maintained in the second quarter (Chart 4.5.2). A breakdown of the output gap by its components suggests that domestic demand and foreign demand conditions both exert an upward pressure on inflation (Box 4.1). In sum, it is assessed that in the second quarter, economic activity started converging to its potential level but aggregate demand is still at an inflationary level.

Chart 4.5.1: Alternative Output Gap Indicators Chart 4.5.2: Output Gap (Average and the Minimum-Maximum Band)

Source: CBRT calculations. Source: CBRT calculations. * Output gap series obtained by aggregating the series of direct output gap indicators (see Inflation Report 2017-I Box 4.2).

2 See Inflation Report 2017-1, Box 4.2, “Alternative Indicators for Output Gap”, p. 52-56.

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Multivariate Filter (Bayesian)

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Box 4.1

Decomposition of Output Gap into its Demand Components The output gap reveals the state of economic activity relative to its potential, non-inflationary level. In other words, it serves as an indicator of business cycle phases in the economy (overheating, cooling, etc.). The output gap is also one of the most important variables taken into account when making monetary policy decisions, whereas another one being the deviation of inflation from the target level. Figuring out the source of any output gap, i.e. to what extent it is domestic demand-driven and foreign demand-driven, is key in terms of policy design. For example, rebalancing-oriented policy tools will work through the relative prices (real exchange rate) channel when there is a foreign demand-driven pressure on economic activity while domestic demand-driven pressures will require spending control in addition to relative prices.

In this box, we estimate a New Keynesian general equilibrium model via the Bayesian method. The estimated total output gap is then decomposed into domestic and foreign demand components. In this respect, this box differs from the previous studies by Öğünç and Sarıkaya (2011) and by Alp, Öğünç and Sarıkaya (2012) at certain points. First of all, this study1 includes a monetary policy reaction function, and accordingly employs a standard Taylor rule. In addition, the inflation target is not taken as exogenous but instead estimated in a time-varying structure consistent with the model. Data set includes eight observable variables from the model, namely, the growth rates of GDP, exports and imports, as well as inflation, real exchange rate, import prices, real interest rates, and global growth. Besides, as distinct from the studies cited above, this study employs the latest 2009-based national income data. The C index that excludes energy, food, alcoholic and non-alcoholic beverages, tobacco, and gold, which is deemed to be more consistent with a Phillips Curve model, is used as the inflation rate. On the other hand, foreign trade series are based on national income definitions.

Table 1: Basic Equations

Domestic Demand Gap

�̂�𝑡 = 𝑑1 ∗ �̂�𝑡−1 + (1 − 𝑑1) ∗ 𝐸𝑡�̂�𝑡+1 + 𝑑2 ∗ (𝑟𝑡 − 𝐸𝑡𝜋𝑡+1 − 𝑟𝑡∗) + 𝜖𝑡

Export Gap

�̂�𝑡 = 𝑥1 ∗ �̂�𝑡−1 + 𝑥2 ∗ 𝑦𝑡∗,𝑐 + 𝑥3 ∗ �̂�𝑡−2 + 𝜀𝑡

Import Gap

�̂�𝑡 = 𝑚1 ∗ �̂�𝑡 + 𝑚2 ∗ �̂�𝑡 + 𝑚3 ∗ �̂�𝑡 + 𝜉𝑡

Phillips Equation

𝜋𝑡 = 𝜆𝑏 ∗ 𝜋𝑡−1 + 𝜆𝑓 ∗ 𝐸𝑡𝜋𝑡+1 + 𝑒2 ∗ �̂�𝑡 + 𝑒3 ∗ (𝑝𝑚𝑡 − 𝜋𝑡) + 𝜁𝑡 ;

𝜆𝑏 + 𝜆𝑓 = 0.99

Accounting Identity

�̂�𝑡 = 𝑦1 ∗ �̂�𝑡 + 𝑦2 ∗ �̂�𝑡 − 𝑦3 ∗ �̂�𝑡

Monetary Policy Reaction Function

𝑟𝑡 = 𝑟𝑡−1∗ + 𝜌𝑟 ∗ (𝑟𝑡−1 − 𝑟𝑡−1

∗ ) + (1 − 𝜌𝑟) ∗ (𝜃𝜋(𝐸𝑡𝜋𝑡+1 − �̅�𝑡) + 𝜃𝑦�̂�𝑡) + 𝜂𝑡

1 This box involves the initial findings of the study by Koca and Kalafatcılar (2018) in progress.


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Basic equations of the model are presented in Table 1. �̂�𝑡 , �̂�𝑡 , �̂�𝑡, �̂�𝑡, denote domestic demand, export, import, and total output gaps, respectively. These variables, defined as “gaps”, are expressed as percent deviations of their current levels from their long-term trends. Accordingly, a positive (negative) output gap value refers to overheating (cooling) of the economy. Domestic demand covers public and private sector consumption and total investments. 𝜋𝑡 shows the inflation rate, defined as a deviation from the term average. �̂�𝑡 refers to the deviation of producer prices-based real effective exchange rate from the equilibrium value. While 𝑟𝑡 is the interest rate adjusted for average inflation, 𝑟𝑡

∗ stands for the natural real interest rate. 𝑝𝑚𝑡

demonstrates the difference of nominal import unit value index in domestic currency from the term average of inflation, whereas 𝑦𝑡

∗,𝑐 shows the cyclical component of the export-weighted global growth index. Finally, �̅�𝑡 denotes the model-consistent inflation target. 𝜖𝑡 , 𝜀𝑡 , 𝜉𝑡 and 𝜁𝑡 refer to stochastic shocks, and 𝜂𝑡 shows the monetary policy shock.

The model, which is composed of 21 equations including main equations and exogenous processes, is estimated for the post-2005 period from a Bayesian perspective. Chart 1 demonstrates the total output gap within the highest and lowest 10-percent posterior density while Chart 2 shows the subcomponents of the output gap.

In the aftermath of the global crisis in 2008, the total output gap remained in the positive area except for short intervals. It moved into the negative area following the sharp decline in economic activity in the third quarter of 2016 triggered by successive shocks. However, it rapidly recovered in the following period and moved back to the positive area where it remained until the second quarter of 2018. Indicator suggests that the economy entered an overheating phase starting from the second quarter of 2017 and the inflationary pressure of aggregate demand conditions consistently increased. It is estimated that economic activity started converging to its potential level as of the second quarter of 2018 in line with the recent rebalancing process in the economy.

Chart 1: Output Gap (%)

* Forecast.

Chart 2 shows the components affecting the course of the total output gap and the magnitude of their effects. The export gap shifted to the negative area following the global crisis at end-2008 and remained there until the end of 2011 due to the deepening stagnation particularly in the euro area. Recovering and moving to the positive area with the emergence of new markets, the export gap exerted an upward pressure on the total output gap until 2016. With the sharp decline in tourism revenues due to geopolitical developments, the export gap remained below its long-term trend throughout 2016 and curbed aggregate demand pressures.

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As a result of the strengthening global demand, the depreciation of the Turkish lira in real terms, and the recovery in the tourism sector in 2017, exports of goods and services rapidly converged to their long-term trend.

The domestic demand gap hovered around the positive area after the global crisis, except for the deceleration periods observed throughout 2012 and in the first half of 2014, and the transitional contraction period in the third quarter of 2016. The import gap largely followed this variable. As of the final quarter of 2016, the economy started to pick up quickly due to policies supporting domestic demand. As a result, domestic demand became the main factor triggering the overheating of the economy in 2017. Accordingly, imports also climbed above their long-term trend.

Chart 2: Subcomponents of Output Gap (%)

* Forecast.

Model estimations indicate that domestic demand is still at an inflationary level despite the slowdown in the second quarter of 2018. During the same period, the import gap shifted to the negative area, which implies a rebalancing in both the rate and composition of growth. Meanwhile, the export gap moved to the positive area following its course just below the neutral level and thus increased the aggregate demand pressures.

To sum up, it is estimated that economy activity started converging to its potential level as of the second quarter of the year. It is projected that this largely domestic demand-driven trend will continue in the second half of the year and aggregate demand-driven inflationary pressures will be subdued. Maintaining the rebalancing process in the economy is crucial to eliminate internal and external imbalances in terms of inflation and current account deficit, and to achieve a stable and sustainable growth path.

References

Alp, H., Öğünç, F. and Sarıkaya, Ç. (2012). Monetary Policy and Output Gap: Mind the Composition. CBRT Research Notes in Economics, 2012-07.

Koca, Y.K. and Kalafatcılar, M.K. (2018). Çıktı Açığının Talep Bileşenlerine Ayrıştırılması (Decomposition of Output Gap into its Demand Components, in Turkish). CBRT, forthcoming.

Öğünç, F. and Sarıkaya, Ç. (2011). Görünmez ama Hissedilmez Değil: Türkiye’de Çıktı Açığı (Invisible but not Imperceptible: Output Gap in Turkey, in Turkish). Central Bank Review, 11(2), 15-28.

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Box 4.2

Products Subject to Project-Based Incentive System and Possible Effects on the Current Account Balance In the recent period, an incentive system has been introduced for high-to-medium value-added investments in selected products by selected firms that require advanced technology. This system is intended to increase employment and reduce the current account deficit in the medium term through investment incentive certificates to be granted to 23 projects of 19 large-scale firms. The product group to receive incentives covers high-tech imported input products that are important particularly for Turkey's industrial production and exports. This coverage is deemed a significant step towards the elimination of structural factors leading to the current account deficit. This box presents an analysis of the short- and medium-term effects of products covered by the incentive system on Turkey's current account deficit.

Chart 1: Net Imports in Incentivized Sectors by Years (Million USD)

Source: TURKSTAT.

Products covered by the project-based incentive system are mainly composed of imported intermediate goods. Products to be manufactured under the subsidized projects are overall categorized into 12 product groups.1 Turkey posts a foreign trade deficit in almost all of these products. An analysis of the change in net imports of products covered by the incentive program in the 2013-2017 period reveals that notwithstanding the increases and decreases in imports of most of the products, net imports remained at a certain level. Chart 1 shows net imports in each product group based on 2017 values. Accordingly, products with the highest level of foreign trade deficit are polymer and polypropylene which are the most important input raw materials in industrial production and exports of chemical and plastic products. Net imports of these two products were USD 7.3 billion in 2017. Considering that the current account deficit was USD 47.4 billion in 2017, it is assessed that these two products alone had an unignorably adverse effect on the current account deficit. On the other hand, it is notable that net imports of solar panels and

1 Processed aluminum, carbon fibers, electrical batteries, heart valves, polyethylene terephthalate (PET), monoethylene glycol (MEG), zinc, railway

vehicles and diesel engines, processed copper, polypropylene, solar panels and accessories, polymer.

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Carbon Fibers

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Catheter, Heart Valves

PET

MEG

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Railway Vehicles and Diesel Engines

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Polymer

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accessories skyrocketed to USD 3.5 billion in 2017 from USD 42 million in 2013. Renewable energy sector investments in the recent years are believed to have been effective in this increase.

Chart 2: Share of Incentivized Products in Net Imports Excl. Gold and Energy (%)

Chart 3: Share of Incentivized Products in Current Account Deficit Excl. Gold and Energy (%)


Total net imports of incentivized products increased by approximately USD 3 billion to USD 17 billion in 2017 from USD 13.6 billion in 2013. Likewise, their total share in net imports of intermediate goods excluding gold and energy rose by nearly two points and reached 30 percent in 2017 (Chart 2). In this respect, products under the incentive system have substantially added to net imports. The share of net imports of these products in the current account deficit excluding gold and energy has been hovering around 40 percent for the last four years (Chart 3). On the other hand, a large portion of these products constitutes the main inputs of chemicals and plastics sectors where the industrial production and exports have registered relatively high rates of increase in recent years. This has the potential to further deepen the current account deficit problem in the following years through the imported input channel. Moreover, as renewable energy investments will increase in the upcoming years, imports of solar panels are expected to grow rapidly and push the current account deficit upwards if the domestic production of solar panels remains low. Therefore, it is anticipated that realizing the projects under the incentive system will considerably alleviate the pressure on the current account balance.

To conclude, the project-based incentive system is intended for mostly imported high-tech intermediate products that are required in industrial production and have a considerable share in the current account deficit. Considering that fixed investments in these products will be large scaled, the projects have the potential to increase the current account deficit in the short term particularly via imports of investment goods. Providing selected large firms with these incentives is also believed to be crucial in terms of the success of investments. Accordingly, although the project-based incentive system will unfavorably affect the cyclical component of current account deficit in the short term through high fixed investment costs, it will positively contribute in particular to the structural component of current account deficit in the medium and long term as the products cited above will be largely produced in Turkey.

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Box 4.3 Nowcasting Turkish GDP Growth: MIDAS Approach GDP data are announced by TURKSTAT at a quarterly frequency while many short-term business statistics, particularly on industrial production, are monitored at monthly, credit developments at weekly, and exchange rates at daily frequencies. In the classical approach, to be able to use different-frequency data in forecasts, high-frequency data are converted to low-frequency data (e.g., the quarterly average of monthly industrial production data is calculated and related to quarterly GDP). However, the Mixed Data Sampling (MIDAS) approach, which is popular in modern practice and is among the methods used in economic activity forecasts (particularly in nowcast models), allows data to be used at its own frequency and forecasts to be revised according to the data release calendar for the lowest-frequency data (Anesti et al., 2017). This box presents an analysis of GDP growth forecasts in Turkey from a MIDAS perspective along with a performance evaluation of various models.

The technical display of the MIDAS method is given in Equation 1. 𝑦𝑡 can be taken as annual, monthly or weekly data. 𝑥𝑡

𝑚 is data at a frequency that is observed m times faster than 𝑦𝑡. For example, if 𝑦𝑡 is quarterly data such as GDP and 𝑥𝑡

𝑚 is monthly data such as the industrial production, then m=3 as monthly data are announced three times a quarter. The number of independent variables rises when the lagged data of the high-frequency indicator, 𝑥𝑡

𝑚, are also used. This may considerably increase the uncertainty in coefficient estimates. However, in the MIDAS method, coefficients can be calculated using polynomials. In this way, a limited number of parameters required by the relevant polynomial are estimated and a large number of coefficients are obtained as a function of these parameters. The "h" in 𝑦𝑡+ℎ denotes the forecast horizon.

𝑦𝑡+ℎ = 𝛽0 + 𝜆𝑦𝑡 + 𝛽1𝐵 (𝐿1𝑚, 𝜃) 𝑥𝑡+𝑤

𝑚 + 𝜀𝑡+ℎ (1)

The fact that the MIDAS method allows for analyses where dependent and independent variables can be used at their own frequencies provides significant flexibility in updating forecasts based on data flow. The range of studies employing the method may give a better idea. Accordingly, some examples include:

i. Revision of quarterly growth forecasts by using daily financial data (Aprigliano et al., 2017),

ii. Revision of global growth forecasts based on monthly data flow for annual growth (Ferrara and Marsilli, 2014),

iii. Daily revision of inflation forecasts (Marsilli, 2017), iv. Forecast of weekly volatility in stock markets via daily data (Alper et al., 2012).

This box includes two applications regarding the analysis of GDP forecasts. First, we analyze the performance of quarter-on-quarter GDP growth nowcasts obtained by using selected indicators derived from production, survey, credit, tax, and sales data (Table 1). While credit data are announced weekly, all explanatory variables are used in monthly frequency since real credit data are employed in nowcasting.

A total of 2,024 models, obtained from combinations of these 24 indicators taken three at a time, have been included in the analysis. For example, one model employs industrial production, PMI and housing loan data whereas another model uses data on industrial production, PMI and automobile sales. The nowcast performance of each indicator may be evaluated individually or a model may employ more than three variables. Pursuing a balance between the information set


59

used in the model and the complexity of the model, three-variable models have been included in the analysis.

Table 1: Information Set Used in Quarter-on-Quarter GDP Growth Nowcast*

IPI- Total industry BTS- Export orders in the last three months

TAX- VAT on imports

IPI- Share of exports <20 BTS- Domestic market orders in the last three months

CREDIT- Total (FX-Adjusted)

IPI- Share of exports >20 ; <40 PMI- Overall CREDIT- Total corporate (FX-Adjusted)

IPI- Share of exports <40 PMI- Production CREDIT- Total consumer

BTS- Production in the last three months

PMI- New orders CREDIT- Housing

BTS- Registered orders PMI- New export orders VEHICLE- Automobile sales

BTS- Production in the next three months

TAX- Total real tax revenues VEHICLE- Light commercial vehicle sales

BTS- CUR TAX- Real VAT on imports ELEC- Electricity generation

* Capitalized expressions in front of variables show the data category to which the relevant variable belongs. IPI: Industrial Production Index, BTS: CBRT Business Tendency Survey, CUR: Manufacturing Industry Capacity Utilization Rate, PMI: Manufacturing Industry Purchasing Managers Index.

Three-variable nowcast models have been ranked according to their performance of nowcasting the GDP growth between 2014Q1 and 2018Q1, and the best 10 models have been identified. The information set at the time the nowcast was made has been taken into account when evaluating the nowcast performance. Accordingly, nowcasts have been generated by using data available as of the second and third months of the reference quarter and the middle of the first and second months of the next quarter. For example, in February 2018, survey indicators pertaining to January will be included in the information set while December 2017 data will be available for industrial production. Coefficient estimates have been revised at each stage of the nowcast.

The four-chart panel starting with Chart 1.a demonstrates the average of the nowcasts of the best 10 models obtained for four different periods based on data flow, and the interval between the highest and lowest nowcasts. Results indicate that nowcast errors diminish due to data flow, particularly for the 2014-2016 period. It is notable that nowcast errors increase starting from 2017.

Chart 1.a: GDP Growth and Nowcasts* (Quarter-on-Quarter Change, %)

Chart 1.b: GDP Growth and Nowcasts* (Quarter-on-Quarter Change, %)

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Chart 1.c: GDP Growth and Nowcasts* (Quarter-on-Quarter Change, %)

Chart 1.d: GDP Growth and Nowcasts* (Quarter-on-Quarter Change, %)

* Shaded areas in the charts show the interval between the highest and lowest forecasts of the best 10 models.

Since the MIDAS method allows data at different frequencies to be processed together, it enables generation of annual growth nowcasts that can be mechanically revised based on data flow (Günay, 2018). Accordingly, the second section in this box offers findings related to the annual growth nowcast. Considering the changes in growth expectations in 2017, the importance of this issue becomes more visible. For example, although growth forecasts for 2017 compiled by the CBRT Survey of Expectations increased throughout the year, the average expectation remained significantly below the actual growth in December (Chart 2). Forecasts released by international institutions throughout the year may also considerably diverge from one another as well as from the actual figures even at year-end (Chart 3). The high levels of forecast errors despite a substantial amount of data accumulation for forecasts towards the end of the year indicate that a judgmental approach may play a significant role in forecasts.

Chart 2: Survey of Expectations-Based Forecasts for GDP Growth in 2017*

Chart 3: GDP Growth Forecasts for 2017 by International Institutions


* Shaded area shows the interval between the highest and lowest forecasts.

Source: European Commission, World Bank, IMF, OECD.

To observe the advantage of effectively integrating the data flow into nowcasts, the annual GDP growth has been estimated by using the month-on-month industrial production growth and quarter-on-quarter GDP growth. However limited the number of data may be, nowcast errors are expected to decrease when data announced throughout the year are effectively employed. For instance, data on growth in the first two quarters and on July industrial production are

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included in the information set in September. Likewise, in December, the information set will include the GDP growth in the first three quarters and the industrial production in October. Consequently, nowcast errors will possibly decrease when actual figures recorded throughout the year are consistently reflected on nowcasts.

The four-chart panel starting with Chart 4.a shows the annual growth nowcasts and actual figures for the 2010-2017 period, as of April, June, September, and December. The reason for choosing these months is that the quarterly GDP is announced in these months (or in the preceding month). A comparison of nowcasts and actual figures reveals that nowcast errors substantially decrease in the second half of the year. In this framework, it may be useful to generate model-based nowcasts for annual growth in addition to the judgmental approach. Although annual growth nowcasts are not expected to be merely model-based, revising nowcasts so that they are consistent with data flow will enable a sounder assessment of the economic outlook.

Chart 4.a: GDP Growth and Nowcasts (Annual Change, %)

Chart 4.b: GDP Growth and Nowcasts (Annual Change, %)

Chart 4.c: GDP Growth and Nowcasts (Annual Change, %)

Chart 4.d: GDP Growth and Nowcasts (Annual Change, %)

This box has presented an analysis of the performance of quarter-on-quarter and annual growth nowcasts generated by employing the MIDAS method that allows for nowcasts based on data at different frequencies. The findings suggest that more accurate estimates can be produced for quarter-on-quarter growth nowcasts through data flow but they also point to the role of judgmental evaluations in the success of nowcasts even with full information set availability. As for annual growth nowcasts, the use of the MIDAS method reduces nowcast errors in the second half of the year, proving that more structural models are needed for long nowcast horizons.

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References

Alper, C. E., Fendoglu, S., and Saltoglu, B. (2012). MIDAS Volatility Forecast Performance under Market Stress: Evidence from Emerging Stock Markets. Economics Letters, 117(2), 528-532.

Anesti, N., Hayes, S., and Moreira, A. (2017). Peering into the Present: The Bank's Approach to GDP Nowcasting. Bank of England Quarterly Bulletin 2017 Q2.

Aprigliano, V., Foroni, C., Marcellino, M., Mazzi, G., and Venditti, F. (2017). A Daily Indicator of Economic Growth for the Euro Area. International Journal of Computational Economics and Econometrics, 7(1-2), 43-63.

Günay, M. (2018). Nowcasting Annual Turkish GDP Growth with MIDAS, CBRT Research Notes in Economics, forthcoming.

L. Ferrara and Marsilli, C. (2014). Nowcasting Global Economic Growth: A Factor-Augmented Mixed-Frequency Approach, Working Papers 515, Banque de France.

Marsilli, C. (2017). Nowcasting US Inflation Using a MIDAS Augmented Phillips Curve. International Journal of Computational Economics and Econometrics, 7(1-2), 64-77.

Financial Conditions and the Monetary Policy

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5. Financial Conditions and Monetary Policy In the second quarter of 2018, the normalization process in monetary policies of advanced economies accelerated, and volatilities increased in global financial markets due to rising protectionism in international trade, as a result of which the risk premium of emerging market economies climbed and their currencies depreciated. Portfolio flows towards emerging market economies have been adversely affected by these developments. In this quarter, Turkey's financial indicators decoupled from other emerging market economies negatively mainly due to domestic uncertainties and the rise in the current account deficit and inflation. On the back of the CBRT's rate hike decisions taken to underpin price stability, slope of the yield curve remained negative.

The deceleration in credit growth continued in the second quarter of 2018 as well. According to the Bank Loans Tendency Survey, in the second quarter of 2018, banks tightened loan standards on commercial loans, and in response, businesses' demand for commercial loans decreased. Banks foresee further tightening in commercial loan standards and an increase in demand for these loans in the third quarter.

The Financial Conditions Index points to a tightening in the second quarter of 2018. Moreover, the decline in the ratio of net credit use to GDP continued due to the decrease in commercial loan supply and the base effect (Chart 5.1). All financial components had a contracting effect on FCI (Chart 5.2).

Chart 5.1: Financial Conditions and Credit Growth* Chart 5.2: Contributions to the FCI


* For further details on measuring FCI, see the CBRT Working Paper No. 15/13.

Net Credit Use is defined as the annual change in the credit stock and it is adjusted for exchange rate. GDP data for the second quarter of 2018 is forecast.

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5.1 Relative Performance in Financial Markets Risk Perceptions and Portfolio Flows

In the current reporting period, upside risks to global inflation outlook were heightened and central banks of advanced economies kept on tightening their monetary policy stances. In fact, compared to the previous reporting period, the Fed is now more likely to make a total of 4 rate hikes till the end of 2018; while at its June meeting, the ECB decided to terminate the asset purchase program at the end of December 2018. These developments fueling volatilities in global markets coupled with increased protectionist discourse have weakened risk appetite. As a result, regional risk premiums of emerging market economies have increased. Meanwhile, Turkey's risk premium has diverged negatively from other emerging economies due to its negative inflation and current account balance outlook as well as domestic uncertainties (Chart 5.1.1). This negative divergence can partly be attributed to the recent increase in Turkey's sensitivity to global developments (Box 5.1). As of February, portfolio flows into emerging economies started to decline with the impact of the volatilities in global markets. During the same period, portfolio flows into Turkey also decreased, and cumulatively, portfolio outflows have exceeded portfolio inflows (Chart 5.1.2). An analysis of portfolio movements by types of markets reveals that outflows mainly occurred in the Government Domestic Debt Securities-DIBS market.

Chart 5.1.1: Regional Risk Premium* (Basis Points) Chart 5.1.2: Cumulative Portfolio Flows to Turkey* (Billion USD dollars)

Source: Bloomberg. Source: CBRT.

* Shows cumulative changes since 2 January 2017. * Includes portfolio inflows to stocks and GDDS market. Repo is included in the GDDS data.

Exchange Rates and Market Rates

In the current reporting period, risk perceptions for emerging economies deteriorated and currencies of these countries depreciated on the back of the appreciation trend of the US dollar and fluctuations in the global financial markets. Geopolitical tensions, outlook on macro indicators such as inflation and current account deficit, and concerns over macroeconomic policy mix increased Turkey's sensitivity to global fluctuations. In this period, the depreciation in the Turkish lira was much higher and assumed a more volatile trend compared to currencies of peer emerging market economies (Chart 5.1.3). Thus, the implied volatility of the Turkish lira increased as well. Nevertheless, volatility in the Turkish lira slightly decreased in July (Chart 5.1.4).

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Chart 5.1.3: Turkish Lira and Emerging Market Currencies against US Dollar (02.01.2017=1)

Chart 5.1.4: Implied FX Volatility against US Dollar (1 Month-Ahead, %)




In the current reporting period, short and long-term interest rates in emerging market economies have been largely flat, whereas market rates in Turkey climbed significantly in May and June (Chart 5.1.5 and Chart 5.1.6).

Chart 5.1.5: 6-Month Market Rates (%) Chart 5.1.6: 5-Year Market Rates (%)


5.2 Credit Conditions Loan Rates, Funding Costs and Interest Rate Spreads

In the second quarter of 2018, banks' funding costs increased. The rise in funding costs was mainly driven by the rise in the CBRT's average funding rate as well as the hike in swap rates fueled by risk premium and exchange rate developments. The modest growth in loans curbed further increase in need for funding and deposit rates. In the second quarter, commercial loan rates outpaced deposit rates, which in turn pushed the loan-deposit rate spread beyond historical averages (Chart 5.2.1 and Chart 5.2.2).

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Chart 5.2.1: Indicators of Banks’ Funding Costs (%) Chart 5.2.2: TL Commercial Loan Rates and TL Deposit Rates* (Flow, Annualized, 4-Week Moving Average, %)

Source: Bloomberg, CBRT. Source: CBRT.

* TL commercial loans excluding overdraft accounts, credit cards and zero-rate loans.

An analysis of commercial loan rates by a breakdown of firm sizes reveals that rates have increased across all sub-categories (Chart 5.2.3). As suggested by the Bank Loans Tendency Survey, in the second quarter of 2018, banks tightened standards of loans that they extended to both SMEs and large corporations. The Survey answers suggest that this tightening was mainly determined by expectations pertaining to general economic activity, outlook for the industrial sector and firms as well as constraints on capital adequacy, and banks' liquidity positions. Moreover, consumer loan rates increased on the back of the rise in personal loan rates (Chart 5.2.4). The Survey results also suggest that funding costs and balance sheet constraints were also influential.

Chart 5.2.3: TL Commercial Loan Rates* (Flow Data, Annualized, 4-Week Moving Average, %)

Chart 5.2.4: Consumer Loan Rates (Flow Data, Annualized, 4-Week Moving Average, %)


* Excluding overdraft accounts, credit cards and zero-rate loans.

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Credit Volume

In the second quarter of 2018, the ratio of net credit use to GDP continued to decrease due to the tightening in commercial loan supply and the base effect that had been observed since the first quarter (Chart 5.2.5). The decline in the total loan growth mainly stems from the deceleration in commercial loan growth (Chart 5.2.6). Actually, as suggested by the Bank Loans Tendency Survey, the decline in loan growth in this quarter can be predicated on the decrease in loan supply and loan demand.

Both commercial and total loan growth rates remained below historical averages in the second quarter of 2018 (Chart 5.2.7 and Chart 5.2.8).

Chart 5.2.5: Domestic Credit Stock and Net Credit Use* (%)

Chart 5.2.6: Annual Loan Growth (Adjusted for Exchange Rates, Y-o-Y % Change)


* GDP data for the second quarter of 2018 is forecast.

Chart 5.2.7: Annualized Total Loan Growth (Adjusted for Exchange Rates, 13-Week Moving Average, %)

Chart 5.2.8: Annualized Commercial Loan Growth (Adjusted for Exchange Rates, 13-Week Moving Average, %)


FX commercial loan growth adjusted for exchange rates moderately decelerated in this quarter. This deceleration was driven by the rise in banks' FX borrowing costs, arrangements pertaining to FX risk

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management, exchange rate developments and the decline in FX loan demand (Chart 5.2.9). Actually, the Bank Loans Tendency Survey results also suggest that banks have significantly tightened credit conditions on FX commercial loans while firms' demand for FX loans decreased in tandem.

In the second quarter of 2018, the rise in banks' funding costs affected loan pricing behavior and in response, consumer loan rates increased while demand for consumer loans decelerated (Chart 5.2.10). Answering the Survey, banks have stated that they have tightened credit conditions on personal loans due to funding costs and balance sheet constraints. In the same quarter, the demand for personal loans decreased due to the fall in consumer confidence, the decline in security purchases and expenditures on consumer durables. On the other hand, there is an acceleration in housing loan growth. This acceleration is attributed to the incentive policies introduced for the sector.

Chart 5.2.9: Annualized TL and FX Commercial Loan Growth (Adjusted for Exchange Rates, 13-Week Moving Average, %)

Chart 5.2.10: Annualized Consumer Loan Growth (13-Week Moving Average, %)


Loan Standards

The results of the Bank Loans Tendency Survey for the second quarter of 2018 suggest that banks have tightened loan standards compared to historical averages and they expect further tightening in the third quarter (Chart 5.2.11). A breakdown of these standards by scale, maturity and currency unit reveals that the tightening will continue across all sub-categories in the third quarter. Nevertheless, the tightening is more evident in FX loans and long-term loans and this trend will continue incrementally in the upcoming quarter.

As for factors affecting commercial loan standards: prospects for general economic activity, outlook for the sector or firms, capital adequacy constraints, liquidity positions and risks to collaterals to be pledged against loans stood out as factors fueling tightening. There has been no factor having a loosening effect on loan standards. As for rules and conditions applied to commercial loans: profit margins, collateral requirements, maturity structure, loan limits and special loan agreement terms had a tightening effect on loan conditions. In other words, all factors except for charges and commissions other than interest, had a tightening impact on loan conditions.

Answers of banks participating in the Survey suggest that firms' demand for commercial loans fell significantly below the historical averages in the second quarter of 2018, but a moderate increase is expected in the upcoming period (Chart 5.2.11). A breakdown by maturities and currency shows that there has been a modest rise in the demand for short-term loans and in TL loans, respectively, whereas the decline in long-term and FX-denominated loans has continued. The demand for FX-denominated

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loans is expected to decline further. Meanwhile demand for short-term loans, TL loans and loans extended to large-scale companies is expected to increase.

Factors affecting the demand for commercial loans reveals that the possibility of debt restructuring has an increasing impact on loan demand while fixed investment, inventory build-up, working capital and alternative financing possibilities have a downward impact on loan demand.

Chart 5.2.11: Commercial Loan Standards and Commercial Loan Demand**

Chart 5.2.12: Consumer Loan Standards and Consumer Loan Demand**


*Data for the third quarter of 2018 is forecast.

**Index values above 100 indicate easing in loan standards; and increased loan demand.

*Data for the third quarter of 2018 is forecast.

** Index values above 100 indicate easing in loan standards; and increased loan demand.

Respondents' answers to questions about consumer loans in the Survey suggest that the modest tightening in loan standards continued in the third quarter as well (Chart 5.2.12). The demand for consumer loans, which was prevalent across all sub-categories in the second quarter, is foreseen to continue in the third quarter driven mainly by the drop in mortgage and vehicle loan demand. Consumer confidence and house market prospects were the two key factors driving mortgage demand down. As for vehicle loans, all factors have driven demand down, while as for personal loans all factors except taxes and similar expenses have had a decreasing impact on demand.

5.3 Monetary Policy Market Developments

In a press release on 28 May 2018, the CBRT announced that the simplification process of the operational framework of monetary policy was completed. It was stated that the one-week repo rate would be the policy rate of the Central Bank and CBRT funding began to be carried out only via weekly repo auctions (Chart 5.3.1). At the BIST Interbank Repo-Reverse Repo Market, the average interest rate, which was calculated excluding the CBRT transactions, had been close to the CBRT funding rate for quite a long time. However, after the amendment in the operational framework, this rate has been hovering around the CBRT's one-week repo rate (Chart 5.3.2).

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Chart 5.3.1: CBRT Funding (2-Week Moving Average, Billion TL)

Chart 5.3.2: Short-term Interest Rates (%)

Source: CBRT. Source: BIST, CBRT.

With the impact of the CBRT's rate hikes in May and June, currency swap rates increased compared to the last reporting period. The increase was also driven by the rise in Turkey's risk premium. As a result, short-term currency swap rates continued to hover above long-term currency swap rates (Chart 5.3.3). As was the case in the last reporting period, Turkey had the smallest yield curve slope among other emerging market economies due to increased monetary policy tightening (Chart 5.3.4).

Chart 5.3.3: Swap Yield Curve (%) Chart 5.3.4: Yield Curve Slopes in Emerging Economies* (% Points)


* Yield curve slope is calculated by taking the difference between 5-year bond yields and 6-month bond yields. For Turkey, swap rates have been used instead of bond yields to calculate the yield curve slope.

Even though the CBRT continues to implement a tight monetary policy stance, inflation compensation increased in the current reporting period because the heightened headline inflation rate has influenced long-term inflation expectations and escalated the uncertainties pertaining to inflation (Chart 5.3.5).

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Despite the significant increase in inflation compensation, the distribution of 24-month-ahead inflation expectations obtained from the CBRT Survey of Expectations reveals that the uptick in inflation expectations in July compared to those in April remained at a limited level (Chart 5.3.6).

Chart 5.3.5: Inflation Compensation (5-Day Moving Average, %)

Chart 5.3.6: Distribution of 24-Month-Ahead Inflation Expectations* (%)

Source: Bloomberg. Source: CBRT.

* Kernel probability density functions are constructed using CBRT Survey of Expectations.

Two-year real interest rates, calculated using inflation expectations data obtained from the CBRT Survey of Expectations, have risen largely in tandem with nominal interest rates (Chart 5.3.7).

Chart 5.3.7: 2-Year Bond Yields and the Real Interest Rate in Turkey* (%)

Source: Bloomberg, CBRT.

*Real interest rate is calculated as the difference between 2-year bond yield and the 24-month-ahead inflation expectations data obtained from the CBRT Survey of Expectations.

Monetary Policy Reaction

The CBRT maintained a tight policy stance against the inflation outlook in 2017. Nevertheless, the accommodative incentives and measures fueled domestic demand and curbed the transmission from monetary policy decisions. For this reason, the CBRT maintained its tight monetary policy stance in January and March 2018. In the April MPC meeting, the CBRT highlighted elevated levels of inflation and risks posed by high inflation expectations on the pricing behavior and decided to implement a measured monetary tightening by raising the LLW lending rate by 75 basis points.

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72

Following the press release on 16 May 2018, which stated that the impacts of unhealthy price formations on inflation outlook were closely monitored, the CBRT decided to hold an interim meeting on 23 May 2018. At this meeting, the CBRT emphasized that the elevated levels of inflation and inflation expectations continued to pose risks to the pricing behavior and accordingly, decided to implement a strong monetary tightening to support price stability and raised the LLW lending rate by 300 basis points to 16.5 percent. At this meeting, the MPC also decided to simplify the operational framework in a short period of time to enhance the predictability of monetary policy and strengthen the transmission mechanism. In fact, in a press release dated 28 May 2018, the CBRT announced that the simplification process was completed. Accordingly, the one-week repo rate was set as the policy rate of the CBRT and it was stated that this rate would be equal to the LLW lending rate, which was 16.50 percent at the time. Moreover, the Central Bank overnight borrowing and lending rates were decided to be determined at 150 basis points below/above the one-week repo rate. Thus, overnight market rates would be determined around the policy rate within a symmetrical corridor of overnight borrowing and lending rates. The new operational framework took effect as of 1 June 2018. The strong policy response of 23 May coupled with the simplification of the operational framework contributed to alleviating the volatilities in domestic financial markets.

In the June MPC meeting, stating that the elevated levels of inflation and inflation expectations continued to pose risks to the pricing behavior, the CBRT decided to further strengthen the monetary tightening. Accordingly, the CBRT increased the policy rate, which is the one week repo rate, from 16.5 percent to 17.75 percent. In the July MPC meeting, the CBRT kept the policy rate unchanged, in order to closely monitor the deceleration in domestic demand and the lagged effects of the monetary policy decisions. However, it was also assessed that the elevated levels of inflation and inflation expectations continued to pose risks to the pricing behavior and it might be necessary to maintain a tight monetary stance for an extended period.

In response to the impact of the unhealthy price formations and excessive volatility in the markets on inflation outlook, after the April MPC meeting, the CBRT introduced some measures in addition to the measures explained above. Accordingly, with a press release on 7 May 2018, the upper limit for the FX maintenance facility within the reserve options mechanism was lowered to 45 percent from 55 percent and tranches were re-arranged. With this change, FX liquidity was provided for banks and TL liquidity was tightened. In a press release on 9 May 2018, it was announced that the daily amount of Foreign Exchange Deposits against Turkish Lira Deposits auctions was increased from 1.25 billion US dollars to 1.5 billion US dollars. Thus, the maximum total outstanding deposit amount in the auctions, which was 6.25 billion US dollars, was allowed to reach up to 7.5 billion US dollars. In another press release on the same day, the updated calendar for Turkish lira-settled forward foreign exchange sale auctions to be held in the second quarter of 2018 was announced. According to the new calendar, the maximum amount of forward foreign exchange sale position was raised to 7.1 billion US dollars. On 24 May 2018, the calendar was revised again and the maximum total amount of forward foreign exchange sale position was increased from 7.1 billion US dollars to 8 billion US dollars. The upper limit for the total amount of forward foreign exchange sale position was determined as 10 billion US dollars until end-2018. Moreover, the CBRT announced in a press release on 25 May 2018 that the repayments of rediscount credits for exports and foreign-exchange-earning services which will be due by 31 July 2018 (included), can be made in Turkish liras at a fixed exchange rate.

Financial Conditions and Monetary Policy

73

Box 5.1

Country Risk Premium and Macroeconomic Conditions When Global Financial Conditions are Tighter Recently, Turkey's risk premium has negatively decoupled from other emerging economies (Charts 1 and 2). Economic factors specific to Turkey were effective in this decoupling in addition to the rise in US bond yields and a decline in international investors' risk appetite as the normalization process in monetary policy of advanced economies become more evident. This box analyzes the economic indicators determining risk premium to shed light on these evaluations. 1

Chart 1: Turkey-EMBI Global (Monthly Average, Basis Points)

Chart 2: Change in EMBI Global in EMEs (Basis Points, 28.02.2018=0)

Source: Bloomberg. Latest Observation: July 2018. Source: Bloomberg. Latest Observation: 10 July 2018.

The risk premium is excess return that an investor asks for extra risk relative to a risk-free asset (such as US bonds) with the same maturity. 2 As discussed in the "External Vulnerability" literature3, the risk premium demanded by the foreign investor depends on several factors such as the country's current account deficit, the ratio of the country's international reserves to foreign exchange requirement, budget outlook, inflation level, sensitivity of company balance sheets to exchange rates and interest movements and other country-specific factors as well as global factors (i.e. global risk appetite, global trade outlook etc.).

Our main question is this: how are the changes in risk premium affected by the above-listed macroeconomic indicators reflecting external vulnerabilities and are these indicators more influential when global financial conditions are tighter?

In the light of these evaluations, the determinants of risk premiums for 8 peer emerging economies were studied in an econometric framework. Countries studied are: Brazil, Colombia, Indonesia, Malaysia, Mexico, Peru, South Africa and Turkey. Sampling period is 2005Q1-2017Q4. The method employed is dynamic system generalized method of moments (system GMM).4 JP

1 For details please see Akçelik and Fendoğlu (2018). 2 This description is based on the assumption that the two assets are in the same currency denomination, are equally liquid, have the same

transaction costs and the international investor has ample sources of funding. 3 For further details on related literature, you can take a look at the IMF reports listed in the references and the references cited in these reports. 4 The system GMM method uses the lagged effects of explanatory variables as instruments to mitigate the endogeneity problem.

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Morgan’s Emerging Markets Bond Index Global (EMBIG) has been used as the risk premium.5 This index measures the difference between the weighted average of yields of bonds issued by Treasury of related emerging country in US dollar terms and the US Treasury bond yields with similar maturity and type.

Table 1: System GMM Regression Results

EMBI Global (Logarithmic Change)

EMBI Global (Logarithmic Change, t-1) 0.225***

(0.025)

Current Account Balance /GDP (Change) -0.020

(0.018)

Current Account Balance /GDP (Change) * Dummy Variable (1 if VIX Change > 0; 0 if VIX Change < 0)

-0.045***

(0.016)

Gross International Reserves/ GDP (Change) 0.008

(0.010)

Gross International Reserves/ GDP (Change) * Dummy Variable (1 if VIX Change > 0; 0 if VIX Change < 0)

-0.028***

(0.012)

Public Budget Balance/ GDP (Change) 0.028***

(0.001)

Public Budget Balance/ GDP (Change) * Dummy Variable (1 if VIX Change > 0; 0 if VIX Change < 0)

-0.042***

(0.004)

Real Annual GDP Growth (Change) -0.008

(0.011)

CPI Annual Inflation (Change) 0.015

(0.015)

International Country Risk Guide (ICRG) Index (Logarithmic Change)

-0.680

(0.461)

Volatility Index (VIX) (Logarithmic Change) 0.570***

(0.013)

Number of Observations 400

Number of Countries 8

Standard deviations are indicated in parenthesis. ***, **, * denotes statistical significance of 1%, 5% and 10%, respectively.

Table 2: Long-term impacts of Macroeconomic Changes on Country Risk Premium6

In Periods of VIX Increase In Periods of VIX Decrease

1 Percentage Point Rise in Current Account Deficit / GDP Ratio

%8.32*** %2.56

1 Percentage Point Drop in International Reserves / GDP Ratio

%2.58*** -%1.01

1 Percentage Point Drop in Budget Balance / GDP Ratio

%1.81*** -%3.61***

***, **, * denotes statistical significance of 1%, 5% and 10%, respectively.

5 Average maturity of EMBI Global Turkey bonds is 12.2 years. In this context, EMBI Global reflects risks pertaining to Turkey's long-term outlook. 6 These ratios are calculated by dividing short-term effects by (1- EMBI Global (Logarithmic Change, t-1)) coefficient. For instance, when the change

in VIX is positive, the long-term effect of current account balance/ GDP is calculated as (-0.020+ (-0.045)) / (1-0.225) = -8.32%.

Financial Conditions and Monetary Policy

75

The results suggest that in periods of adverse global financial conditions, the external vulnerability indicators affect changes in risk premium considerably and at a statistically significant level (Table 1 and 2)7,8. For instance, in periods of decreasing global risk appetite (when VIX rises), a 1 percentage point increase in current account deficit/ GDP ratio pushes up country risk premium by 8.32 percent in the long-term; in periods of positive global conditions, this impact weakens. Similarly, in periods of tighter global financial conditions (when VIX increases), a 1 percentage point drop in the international reserves/ GDP ratio leads to a 2.58 percent rise in country risk premium; whereas this impact is not significantly strong in periods of positive global conditions. A 1-percentage point decline in budget balance/ GDP ratio causes upward decoupling in country risk premium, particularly when global conditions are adverse.

These effects are significantly higher compared to the ones in periods of positive global risk appetite (when VIX is decreasing) (Tables 1 and 2). Similar results have been also found when the US dollar index (DXY) is used for global financial conditions (Table 3).

Table 3: Long-Term Effects of Macroeconomic Changes on Country Risk Premium

In Periods of DXY Increase In Periods of DXY Decrease

1 Percentage Point Rise in Current Account Deficit / GDP Ratio

%5.55*** %4.84***

1 Percentage Point Drop in International Reserves / GDP Ratio

%2.78*** -%2.59

1 Percentage Point Drop in Budget Balance / GDP Ratio

%1.60*** -%6.31***

***, **, * denotes statistical significance of 1%, 5% and 10%, respectively.

To sum up, when global financial conditions become tighter, country-specific indicators have stronger effect on country risk premium. Therefore, in order to achieve a lasting improvement in risk premium in periods of decreasing global risk appetite, it is crucial to achieve improvement in these macro indicators.

References

Akçelik, F. and Fendoğlu, S. (2018). “When they count the most? External vulnerability indicators when global financial conditions slide”, forthcoming.

IMF (2000). “Debt- and Reserve-Related Indicators of External Vulnerability”, Staff Papers. url: https://www.imf.org/external/np/pdr/debtres/debtres.pdf

IMF (2008). “Vulnerability Indicators” url: https://www.imf.org/external/np/exr/facts/vul.htm

7 Due to the nature of the estimation method, conditional estimates were used when estimating these effects, assuming other factors were

constant. For instance, when calculating the effect of deterioration in the budget balance, the current account deficit, reserves and other explanatory variables have been assumed constant. In this respect, should a worsening of the budget balance accompany a deterioration of the current account balance, the combined impact of the budget balance deterioration on the risk premium would be higher.

8 The actual values of macroeconomic indicators have been used here. It should be noted that the change in expectations about these indicators would affect the change in risk premium instead of actual changes in these indicators. Our identification assumption here is that changes in expectations are generally in line with actual changes.

https://www.imf.org/external/np/pdr/debtres/debtres.pdf

https://www.imf.org/external/np/exr/facts/vul.htm


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Public Finance

77

6. Public Finance In the first half of 2018, fiscal policy supported economic growth through not only measures and incentives, but also public consumption and particularly investment expenditures. Due to the expenditures caused by incentives to boost investment, employment and exports as well as the increase in current transfer expenditures, the budget deficit recorded a widening in the first half of the year. It is projected that the forecast slowdown in economic activity in the second half of the year will have possible downside effects on tax revenues and the uptrend in transfer expenditures will persist in the remainder of the year. Given these projections, the budget deficit is likely to increase further in the period ahead.

In the first half of 2018, despite the favorable performance of tax revenues, the rise in interest and primary expenditures accompanied by the slowdown in the growth rate of non-tax revenues led to a marked widening in the budget deficit compared to the same period last year. Meanwhile, restructuring of taxes and some other receivables coupled with the revenues to stem from the zoning amnesty as well as a possible rise in privatization revenues are estimated to curb the widening in the budget deficit.

In 2017, the public financing need that increased in tandem with the accommodative fiscal policy to boost economic activity was mostly met through domestic borrowing, and the domestic debt rollover ratio stood at 125.6 percent. In the first half of 2018, the cost effect induced by temporary measures and incentives adopted in 2017 on the budget waned partially, leading the domestic rollover ratio to recede notably with respect to last year, to 101.6 percent. On the other hand, due mainly to the rising of the financing need that increased owing to public transfer expenditures, the domestic rollover ratio is planned to be 122 percent in the July-September period, according to the Treasury's borrowing program.

6.1 Budget Developments The central government budget deficit, which was 25.2 billion TL in the January-June period of 2017, increased to 46.1 billion TL in the same period of 2018 (Table 6.1.1). The budget deficit posted a year-on-year increase due to budget expenditures that proved higher than budget revenues.

In this period, tax revenues grew by 19.8 percent year-on-year. However, non-tax revenues restricted the increase in central government budget revenues rising to a limited extent of 10.6 percent. On the other hand, interest expenditures proved more notable owing to the rise in borrowing costs in this period. In the first half of 2018, the primary balance posted a deficit of 12.3 billion TL as primary expenditures increased at a faster rate than budget revenues.

Table 6.1.1: Central Government Budget (Billion TL)

January-June

2017 January-June

2018 Rate of

Increase (%) Realization/ Budget

Target (%)

Central Government Budget Expenditures 324.4 399.7 23.2 52.4

Interest Expenditures 27.0 33.8 25.3 47.2

Primary Budget Expenditures 297.4 365.9 23.0 52.9

Central Government Budget Revenues 299.2 353.6 18.2 50.7

I. Tax Revenues 246.1 294.8 19.8 49.2

II. Non-Tax Revenues 53.1 58.8 10.6 60.3

Budget Balance -25.2 -46.1 82.6 69.9

Primary Balance 1.8 -12.3 -799.9 -212.7

Source: Ministry of Finance.

In June 2018, it is estimated that the ratio of annualized budget deficit to GDP will be 2 percent; while the primary budget balance to GDP ratio will be -0.1 percent (Chart 6.1.1). These ratios indicate some deterioration in the budget balance compared to the previous quarter.


78

Chart 6.1.1: Central Government Budget Balances (Annualized, % of GDP)

Chart 6.1.2: Central Government Budget Revenues and Primary Expenditures (Annualized, % of GDP)

Source: Ministry of Finance. Source: Ministry of Finance.

*Forecast. *Forecast.

The central government primary expenditures to GDP ratio is expected to display a year-on-year decline to 20.5 percent in the second quarter of 2018. Likewise, the central government budget revenues to GDP ratio is estimated to exhibit a year-on-year decline to 20.3 percent because of lower non-tax revenues in the first half of the year (Chart 6.1.2).

Central government primary budget expenditures rose by 23 percent year-on-year to 365.9 billion TL in the first half of 2018 (Table 6.1.2). In this period, the upsurge in capital expenditures and capital transfers, indicative of public investments, remained as the leading factor to push expenditures upwards. Meanwhile, current transfers, the most significant item in primary expenditures, posted a rather limited rise of 14.5 percent in January-June 2018. Although grant payments to retirees made in June increased current transfers, the base effect stemming from the postponement of insurance premium payments for the first three months of 2017 to the last quarter of the year dampened health, pension and social benefit expenditures limiting the increase in current transfers. It should be noted that the contraction led by the base effect will last until the last quarter of the year, but the grant payments to retirees for the Eid al-Adha (Sacrifice Feast) will increase current transfers in the period ahead. On the other hand, in the second quarter of 2018, the borrowing item surged in June as the debts of university hospitals that accumulated due to medical equipment and medication were partially met by the Ministry of Finance.

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Public Finance

79

Table 6.1.2: Central Government Primary Expenditures (Billion TL)

January-June

2017 January-June

2018 Rate of Increase

(%) Realization/

Budget Target (%)

Primary Budget Expenditures 297.4 365.9 23.0 52.9

1. Personnel Expenditures 81.8 98.6 20.5 53.8

2. State Premium Payments to SSI 13.4 16.4 22.6 53.2

3. Purchase of Goods and Services 26.4 30.7 16.3 46.5

4. Current Transfers 143.8 164.7 14.5 55.0

a) Duty Losses 2.5 3.6 40.1 50.9

b) Health, Pension and Social Benefit Expenditures

76.0 75.0 -1.4 55.3

c) Agricultural Support Payment 8.2 10.6 28.7 72.9

d) Allocated Revenues 34.5 45.6 32.1 50.7

e) Household Transfers 8.3 13.5 61.9 63.7

5. Capital Expenditures 21.0 35.6 69.6 51.7

6. Capital Transfers 4.4 8.1 81.4 52.6

7. Lending 6.6 11.9 78.9 58.6

Source: Ministry of Finance.

Central government general budget revenues increased by 18.3 percent year-on-year to 339.5 billion TL in the January-June period of 2018 (Table 6.1.3). Revenues generated by the income tax, corporate tax and VAT on imports performed quite well, while the increase in domestic VAT revenues and SCT collection remained limited. The rise in income tax collection is affected by the favorable course of employment. The decision taken in May stating that if fuel prices increase due to oil prices and the exchange rate, the SCT collection would be lowered so that the final price can be kept unchanged, dampened the revenues from those taxes. The upsurge in VAT in imports is attributed to the rise in the exchange rate. Although enterprise and property revenues increased due to the Central Bank profit transfers, non-tax revenues performed weakly as privatization revenues posted a year-on-year decline. In the upcoming period, revenues to be generated by the restructuring of taxes and other receivables as well as the zoning amnesty are likely to affect budget revenues positively.

Table 6.1.3: Central Government General Budget Revenues (Billion TL)

January-June

2017 January-June

2018 Rate of Increase

(%) Realization/

Budget Target (%)

Genel Budget Revenues 287.1 339.5 18.3 49.8

I-Tax Revenues 246.1 294.8 19.8 49.2

Income Tax 50.3 63.4 26.1 51.7

Corporate Tax 27.0 34.7 28.4 52.8

Domestic VAT 25.9 29.5 14.1 44.7

SCT 61.0 67.7 11.0 46.2

VAT on Imports 44.4 55.3 24.6 51.4

II-Non-Tax Revenues 41.0 44.7 9.0 54.6

Enterprise and Property Revenues 14.7 19.3 32.0 96.0

Interests. Shares and Fines 16.9 19.8 17.1 42.6

Capital Revenues 7.0 4.1 -40.5 34.3

Source: Ministry of Finance


80

In the second quarter of 2018, real tax revenues recorded an annual uptick of 14.0 percent (Chart 6.1.3). Across sub-items, domestic VAT and SCT revenues increased remarkably in real terms, while the rise in VAT revenues on imports remained rather limited in the first half of 2018 (Chart 6.1.4).

Chart 6.1.3: Real Tax Revenues (Year-on-Year Percentage Change)

Chart 6.1.4: Real VAT and SCT Revenues (Year-on-Year Percentage Change)

Source: Ministry of Finance Source: Ministry of Finance

6.2 Developments in the Public Debt Stock In the first quarter of 2018, both the total public net debt stock and the EU-defined general government nominal debt stock to GDP ratio remained unchanged in year-on-year terms. The EU-defined general government nominal debt stock to GDP ratio stood at 28.4 percent in the first quarter of 2018 (Chart 6.2.1).

Chart 6.2.1: Public Debt Stock Indicators Chart 6.2.2: Composition of the Central Government Debt Stock * (%)

Source: Treasury and the Ministry of Finance Source: Treasury and the Ministry of Finance

* As of June * As of June

In the first half of 2018, the shares of fixed-rate and floating-rate securities in the total debt stock have decreased, while those of FX-denominated and FX-indexed securities have increased since 2017 (Chart 6.2.2). Domestic borrowing has been financed mostly by fixed-rate securities in this period.

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Chart 6.2.3: Average Maturity of Domestic Cash Borrowing and the Average Term-to-Maturity of the Domestic Debt Stock (Month)

Chart 6.2.4: External Borrowing through Bond Issues

Source: Treasury and the Ministry of Finance Source: Treasury and the Ministry of Finance

* As of June * As of June

The average term-to-maturity of the domestic debt stock stood at 49.8 months as of June 2018 (Chart 6.2.3). In the January-June period of 2018, external borrowing by bond issues amounted to 4 billion USD, with an average maturity of 10.3 years (Chart 6.2.4). The external debt rollover ratio receded to 56.5 percent year-on-year in June 2018.

With a year-on-year decline, the domestic debt rollover ratio fell to 101.6 percent in the first half of 2018 (Chart 6.2.5). The average domestic borrowing real interest rate1 has increased over the past few months (Chart 6.2.6).

Chart 6.2.5: Total Domestic Debt Rollover Ratio (%) Chart 6.2.6: Treasury Auctions Interest Rate and Maturity Structure*

Source: Treasury and the Ministry of Finance

* As of June Source: Treasury and the Ministry of Finance

* As of June

1Real interest rate is calculated by subtracting the 12-month-ahead inflation expectations of the CBRT Survey of Expectations from nominal interest

rates at the Treasury’s auction.

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Medium-Term Projections

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7. Medium-Term Projections This chapter summarizes the underlying forecast assumptions and presents the medium-term inflation and output gap forecasts as well as the monetary policy outlook over the next three-year horizon.

7.1 Current State, Short-Term Outlook and Assumptions Changes in Key Forecast Variables

In the second quarter of 2018, consumer inflation accelerated to a level significantly higher than the April forecast (Table 7.1.1). The main drivers of the deviation of inflation forecasts were the markedly higher-than-expected import prices in Turkish-lira terms and food prices, particularly for unprocessed food (Charts 3.2.2 and 3.3.3). Price hikes spread across all subcategories, while indices for underlying trends recorded a notable deterioration. High inflation seems to weigh on pricing behavior through both expectations and backward-indexation.

As suggested by GDP and employment data released in June and backward revisions, in the first quarter of 2018 economic activity was slightly stronger than the April forecast. Accordingly, output gap forecasts are revised up for the first quarter of 2018. However, owing to the sharp depreciation of the Turkish lira and heightened uncertainty perceptions, financial market volatility increased recently, causing financial conditions to be tighter than expected. Thus, having estimated that demand conditions will slow at a faster rate in the second quarter relative to its April Inflation Report forecasts, the Bank has revised its output gap forecast down (Table 7.1.2). The output gap forecasts for the upcoming period are based on the assumptions that fiscal policy will provide increased contribution to rebalancing and that risk sentiment will improve gradually.

Table 7.1.1: Changes in Key Forecast Variables*

2018-I 2018-II

Output Gap 1.8

(1.4)

0.4

(0.8)

Consumer Inflation

(Quarter-end, Annual % Change)

10.2

(10.2)

15.4

(11.1)

Inflation excl. Unprocessed Food, Tobacco and Alcohol (CPIX) (Quarter-end, Annual % Change)

11.4

(11.4)

15.2

(12.9)

* Numbers in parentheses denote the values from the April Inflation Report.

The tighter-than-expected financial conditions were largely due to both global conditions and domestic factors in the inter-reporting period. In the second quarter, mounting prospects for tighter monetary policies across advanced economies, particularly the US, created more volatility in global financial markets while the uncertainty over trade protectionism in the US dampened the risk sentiment towards emerging economies, causing country risk premiums to rise and portfolio flows to weaken. The outlook for macro indicators such as inflation and current account deficit and worries over the macro policy mix, along with geopolitical tensions, rendered Turkey more vulnerable to global fluctuations and caused financial indicators to diverge negatively from other emerging economies. Due to higher risk premium and lower portfolio flows, the depreciation and volatility in the Turkish lira were higher compared to the currencies of other emerging economies in this period.

On the credit market front, the spread between commercial loan rates and deposit rates appears to have widened in the second quarter while annual exchange rate-adjusted loan growth slowed steadily. The


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Bank Loans Tendency Survey also indicates a tightening of lending standards for the second quarter, which may continue into the third quarter.

The risks posed to pricing behavior by unhealthy price formations in the market and elevated levels of inflation and inflation expectations required a more aggressive monetary tightening stance by the CBRT in comparison to the April projection. At the MPC meetings in May and June, the Bank hiked the policy rate by a total of 425 basis points and completed the simplification process regarding the operational framework of monetary policy on 1 June 2018 to improve the predictability of monetary policy and strengthen the monetary transmission mechanism. At its July meeting, the MPC kept the policy rate unchanged considering the need to monitor the slowdown in domestic demand and the lagged effects of monetary policy, but nevertheless stated that monetary policy may have to remain tight for an extended period due to risks to pricing behavior.

Assumptions for External Variables

Global Growth

Data released in the inter-reporting period signal a more stable US growth but a slightly slowing growth momentum in the euro area for the first quarter of 2018. According to June surveys of Consensus Forecasts, growth forecasts for end-2018 are revised up for the US and down for the euro area, compared to the previous reporting period. Global growth outlook will likely remain favorable in the upcoming period, albeit somewhat moderating in the second quarter compared to the projections of the previous reporting period. Thus, the assumption for the annual growth rate of the export-weighted global production index, a measure for Turkey’s external demand, is revised slightly down for 2018 (Chart 7.1.1). Accordingly, Turkey's external demand outlook for 2018 seems slightly weaker, largely due to the falling euro area demand, but remains promising.

Chart 7.1.1: Export-Weighted Global Production Index* (Annual Average % Change)

Sources: Bloomberg, Consensus Forecasts, CBRT.

* Shaded area shows the forecast period.

Import Prices

Recent increases in crude oil prices on both spot and futures markets drove assumptions for crude oil prices in the April Inflation Report upwards from 68 USD to 73 USD for 2018 and from 65 USD to 73 USD for 2019 on average (Table 7.1.2, Chart 7.1.2). The assumptions for average annual increase in import prices in USD terms were revised upwards for 2018 and 2019 on account of the recent developments (Table 7.1.1, Chart 7.1.3).

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Chart 7.1.2: Revisions to Oil Price Assumptions* (USD/bbl) Chart 7.1.3: Revisions to Import Price Assumptions* (Index, 2010=100)


* Shaded area shows the forecast period. * Shaded area shows the forecast period.

Monetary Policies of Advanced Economies

The decisions taken at the Fed and ECB meetings that followed the release of the April Inflation Report hint at a slightly faster pace of global monetary policy normalization in comparison to the previous reporting period. The Fed raised its policy rate for the second time this year at its June meeting while the ECB decided to end its bond-buying program in December 2018 and affirmed that there would be no rate hikes until the summer of 2019. Therefore, the exogenous assumption for the foreign interest-rate path is revised slightly upwards compared to the April report (Chart 7.1.4). In the second quarter of 2018, growing protectionist measures in international trade hampered global risk appetite, hitting financial markets across emerging economies. Our forecasts are based on the assumption that the global risk sentiment will not worsen further over the upcoming period.

Chart 7.1.4: 3-Month US Bond Rates* (Quarter-end, %)

Source: June Survey of Consensus Forecasts.

* Shaded area shows the forecast period.

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Unprocessed Food Prices

Another external variable underlying medium-term forecasts is the path of unprocessed food prices. Unprocessed food inflation hit 23.2 percent at the end of the second quarter of 2018, significantly exceeding the assumptions cited in the April Inflation Report. This upsurge was mostly driven by supply shortages in some products and exchange rate developments. Unprocessed food inflation is assumed to converge to its historical averages and decline to 12 percent at the end of the year, as prices of some vegetables and fruits are expected to normalize with the supply of new products in the period ahead. Against this background, the food inflation forecast is revised upwards from 7 percent to 13 percent for end-2018, and from 7 percent to 10 percent for end-2019 (Table 7.1.2).

Fiscal Policy, Administered Prices and Tax Adjustments

Fiscal policy remained supportive of economic activity. Some arrangements on administered prices and tax adjustments curbed further rise in inflation. By lowering proportional taxes on tobacco products as of July, any inflationary pressure from cigarette prices is avoided (Box 3.1). The new sliding-scale pricing implementation since May prevented spillovers from higher international oil prices and exchange rates into fuel prices. The Bank's forecasts reflect the assumption that the sliding-scale pricing methodology will remain valid until the end of the year. On the other hand, given the possible pass-through from exchange rates and oil prices to costs, it is assumed that energy items excluding fuel will witness price adjustments at higher rates in the third quarter than those envisaged in the April Inflation Report.

Medium-term projections are based on a framework entailing a fiscal policy focused on lowering inflation in the medium term and conducted in coordination with the monetary policy. Accordingly, our forecasts are based on a scenario in which the support of the public sector for economic activity is replaced by a neutral stance, particularly in 2019, the growth of spending and current transfers is therefore more subdued, and government-controlled prices and wages are set broadly consistent with inflation targets to reduce backward-indexation. The strong policy coordination to lower inflation and achieve macroeconomic rebalancing is envisaged to gradually improve the risk premium and uncertainty perceptions (Box 7.1).

Table 7.1.2: Revisions to Assumptions*

2018 2019

Export-Weighted Global Production Index (Annual Average % Change) 2.6

(2.9) 2.7

(2.7)

Oil Prices (Average, USD) 73

(68) 73

(65)

Import Prices (USD, Annual Average % Change) 6.3

(4.8) 0.5

(-1.0)

3-Month US Bond Rates (Year-end, %) 2.3

(2.2) 2.9

(2.8)

Food Price Inflation (Year-end % change) 13.0 (7.0)

10.0 (7.0)

* Numbers in parentheses denote the values from the April Inflation Report.


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7.2 Medium-Term Forecasts With a tight policy stance that focuses on bringing inflation down through enhanced policy coordination, inflation is projected to converge gradually to the target. Accordingly, inflation is projected to be 13.4 percent at the end of 2018 and then fall to 9.3 percent at the end of 2019 and to 6.7 percent at the end of 2020 before stabilizing around 5 percent over the medium term. With a 70 percent probability, inflation is expected to be between 12.5 percent and 14.3 percent (with a mid-point of 13.4 percent) at end-2018, between 7.6 percent and 11.0 percent (with a mid-point of 9.3 percent) at end-2019 and between 4.8 percent and 8.6 percent at the end of 2020 (with a mid-point of 6.7 percent) (Chart 7.2.1). Forecasts are based on an outlook that the tight monetary policy stance will be maintained for an extended period.

Chart 7.2.1: Inflation and Output Gap Forecasts*

Sources: CBRT, TURKSTAT.

*70 percent confidence interval.

In this regard, after rising to 15.4 percent in June, annual consumer inflation is expected to fall to 13.4 percent by the end of the year. This forecast means an upward revision of 5 points relative to the April Inflation Report (Chart 7.2.2). Of this rise, 2.3 percentage points came from the revision in import price assumption in TL terms because of the developments stemming from oil prices and exchange rates. Oil and exchange rate-driven cost pressures on non-fuel energy prices were also factored into this revision. Meanwhile, the assumption that the sliding-scale pricing implementation will remain in place until the end of the year curbs the fuel price-driven upward effect of these cost factors on the inflation forecast. Food inflation, which was revised upwards from 7 percent to 13 percent, contributes to the revision in end-year consumer inflation forecast by 1.4 percentage points. The high inflation forecast discrepancy in the second quarter coupled with the deterioration in pricing behavior is estimated to add 1.3 percentage points to the inflation forecast. The rise in the prices of alcoholic beverages on the back of the increased special consumption tax constitutes 0.1 percentage points of the total revision. The output gap estimates, which are revised downwards compared to the previous reporting period, are expected to decrease the end-2018 consumer inflation forecast by 0.1 percentage points.

Meanwhile, the inflation forecast for end-2019 has been revised upwards from 6.5 percent to 9.3 percent (Chart 7.2.2). Of this 2.8-point upward revision to the April Inflation Report forecast, 1.5 percentage points stemmed from the upward revision in oil and import price assumptions in TL terms, while 0.7 percentage points came from the food price assumption rising from 7 percent to 10 percent. While

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adjustment for the higher inflation outturn and deterioration in the underlying trend drove the forecast 1 percentage point higher, the downward revision to the output gap lowered the forecast by 0.4 points.

Chart 7.2.2: Inflation Forecast Chart 7.2.3: Output Gap Forecast

Sources: CBRT, TURKSTAT. Source: CBRT.

In the forecast framework described above, annual consumer inflation is projected to display a modest rise in the third quarter and to fall in the final quarter to 13.4 percent at the end of the year. Under the assumption that there will be no additional rise in Turkey’s risk premium driven by global or domestic developments, the disinflation process throughout 2019 will be supported by the tight monetary policy stance and the determined implementation of inflation-oriented policy coordination, as well as economic activity and loan growth converging to a milder path.

With a view to reduce the tradeoffs regarding disinflation at the current juncture and to enhance the resilience of the Turkish economy, and also considering the high levels of inflation and elevated global risks, the prospective contribution from fiscal and macroprudential policies to the rebalancing process is of critical importance (Box 7.1). The main outlook is based on a framework in which the negative divergence of risk perceptions regarding Turkey would be largely taken back so that depreciation pressures on the Turkish lira would be alleviated as a result of the macro policy mix formulated in a coordinated way prioritizing the disinflation process. Accordingly, a moderate appreciation trend was assumed in the real exchange rate. Moreover, while formulating forecasts, it was envisaged that this policy coordination would stop the extended deterioration in inflation expectations and contribute in particular to the gradual convergence of medium-term inflation expectations to the target.

The enhanced coordination between macroeconomic policies is judged to alleviate the decelerating impact of increased financial volatility and uncertainty perceptions on domestic demand and limit the tightening of financial conditions. Therefore, output gap estimates for the second and third quarters, which were revised downwards significantly compared to the April Inflation Report, are projected to trend down moderately in the fourth quarter. Economic activity is expected to start contributing to disinflation in the second half, as domestic demand decelerates. Output gap forecasts for 2019 are lower compared to the April Inflation Report, and imply an outlook where economic activity gradually recovers and converges to the underlying trend (Chart 7.2.3).

Unpredictable price fluctuations in items beyond the monetary policy domain, such as unprocessed food, alcoholic beverages and tobacco products, are among major factors that cause a deviation in inflation forecasts. Therefore, inflation forecasts excluding unprocessed food, alcoholic beverages and tobacco products are also publicly announced. Thus, Chart 7.2.4 shows inflation forecasts excluding unprocessed food, alcoholic beverages and tobacco products. Similar to headline consumer inflation, the CPI excluding

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unprocessed food and tobacco is expected to remain elevated through 2018, trend down in 2019 and decline gradually to about 6 percent in the medium term.

Chart 7.2.4: Forecast of Inflation Excluding Unprocessed Food, Alcoholic

Beverages and Tobacco Products *

Sources: CBRT, TURKSTAT.

*70 percent confidence interval.

Comparison of the CBRT’s Forecasts with Inflation Expectations

At present, high level of inflation appears to have been triggered not only by cost increases and demand-side pressures, but deterioration in pricing behavior and inflation expectations also contribute to the economy-wide diffusion of the tendency to raise prices. Currently, 24- month-ahead inflation expectations of the CBRT Survey of Expectations’ respondents are significantly above the Bank's forecasts (Table 7.2.1). As medium-term inflation expectations exceed the uncertainty band, it is essential that a monetary policy strategy designed to keep inflation expectations firmly anchored be implemented in coordination with other economic policies and that the joint determination to bring inflation down be strongly communicated. The support of fiscal policy for rebalancing and the adjustment of government-controlled prices and wages in line with inflation targets to reduce backward indexation will also contribute to better expectation management.

Table 7.2.1: CBRT Inflation Forecasts and Expectations

CBRT Forecast CBRT Survey of Expectations*

Inflation Target

2018 Year-end 13.4 13.9 5.0

12-Month Ahead 10.4 11.1 5.0

24-Month Ahead 7.5 9.5 5.0

Source: CBRT.

* As of July 2018.

7.3 Key Risks to Inflation Forecasts and the Likely Monetary Policy Response The outlook that the medium-term projections presented in the Inflation Report is based on the Monetary Policy Committee’s judgments and assumptions. Nevertheless, various risks to these factors may affect the inflation outlook and necessitate changes in the monetary policy stance envisaged in the baseline scenario.

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Risks to the medium-term inflation outlook are mostly on the upside. Risks that have the potential to change the outlook that the baseline scenario hinges on are as follows:

Risks to the effectiveness of the coordination between the monetary and fiscal policies;

A deterioration in pricing behavior and expectations formation;

Weaker capital flows towards emerging market economies;

Persisting volatilities in financial markets stemming from domestic factors;

Further supply-side tightening in bank loans;

Likely adverse impacts of global protectionist trade policies on economic activity, trade volume and prices;

Rise in crude oil import prices;

Sustained rise in food prices.

Table 7.3.1 summarizes how these risks might affect the inflation forecasts reported in the previous section.

A weaker coordination between monetary and fiscal policy than in the baseline scenario is regarded as a risk with respect to disinflation and macroeconomic rebalancing. This coordination has two pillars. Firstly, it is important that the administered prices, tax adjustments and incomes policies are formulated in a way to help diminish the backward-indexation behavior. The second pillar is to implement countercyclical fiscal policy to ensure the rebalancing of the economy. The demand-side pressures on prices may continue if the supportive impact of expansionary fiscal policy measures on domestic demand and economic activity persists. Amid further tightening in global financial conditions and also taking into account the current high levels of inflation and the current account deficit, this would lead to a climb in Turkey’s risk premium, an increased pressure on exchange rates, and hence, a tighter monetary policy stance would be required to decrease inflation.

Another important risk to inflation outlook in the upcoming period would be further deterioration in the pricing behavior. Under a conjuncture of high inflation rates and risk premium level and in case of a failure in implementing the macroeconomic rebalancing process rapidly and effectively, inflation and exchange rate expectations may feed each other and undermine the disinflation process. In such a case, any further deterioration in the pricing behavior may necessitate a tighter monetary policy stance for longer in order to lower inflation.

Moreover, there are also risks stemming from global monetary policies and risk appetite developments that may lead to a decline in capital flows towards emerging economies and feed into exchange rate volatility. If unhealthy price formations and excessive volatility occur in the markets due to fluctuations in global liquidity conditions, the CBRT may continue using liquidity measures intended for providing the FX liquidity needed in the market in a timely, controlled and effective manner, and it may introduce additional tightening in monetary policy to curb the impact of these risks on inflation and inflation expectations.

Although the forecasts in the previous section are based on an outlook of moderately slowing economic activity, in the case of high market volatility and additional depreciation of the Turkish lira, firms’ cash flows and balance sheets may be adversely affected and financial conditions may tighten further. Likewise, a significant deceleration in the rate of increase in house and commercial real estate prices may decrease the value of collaterals that the firms put up against loans and firms may be exposed to tighter credit conditions. Should the risks mentioned materialize, they could lead to a more significant slowdown in economic activity than envisaged. The policy mix that would be employed in such a case will be very important for preventing the financial conditions from falling into an unproductive tightening cycle. A strong coordination to be established between the financial sector policies addressing the balance sheet


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effects in particular and the monetary policy focusing on inflation will enhance the effectiveness of the policies.

On a global scale, the likely adverse impact of protectionist trade policies on economic activity, trade volume and prices may have a downward impact on inflation in Turkey mainly through the external demand channel. On the other hand, if these trade policies cause a rise in global inflation, countries involved in trade protectionism may tighten their monetary policies and the global risk appetite may deteriorate. In this case, the likely depreciation in Turkish lira will necessitate a policy response proportionate to the impact of this depreciation on inflation.

There are also supply-side risks to food and crude oil prices that may affect inflation adversely. The CBRT's monetary policy response will be determined in such a way to curb a possible deterioration in inflation expectations and pricing behavior, taking into account the direct and secondary effects of respective risks on inflation.

Table 7.3.1: Key Risks to Inflation Forecasts and Possible Impact Channels*

Risk Assessment of Risks as against the Baseline Scenario and Possible Impact on Inflation (↑ | ↔ | ↓)

Indicators Monitored

Risks to effective coordination between monetary and fiscal policies

Demand Channel:

The persisting expansionary effect of fiscal policy on domestic demand and economic activity may lead to continued demand pressure on prices.

Risk Premium:

Insufficient coordination between fiscal and monetary policies, along with lack of contribution from fiscal policy to macroeconomic rebalancing, particularly the current account balance and inflation, at a desired level, may cause an increase in the country's risk premium.

Administered Prices and Tax Adjustments:

Maintaining the practice of backward-indexation in government-set wages, other administered prices and tax adjustments may delay the disinflation process.

Terminating the administrative arrangement that alleviates the impact of crude oil prices and exchange rate fluctuations on fuel prices in an inflationary conjuncture may affect inflation adversely.

↑

↑

↑

↑

Fiscal policy measures and MTP preparations

Developments regarding the interaction of monetary and fiscal policies

Domestic demand indicators

Developments in expenditure items sensitive to fiscal policy measures

Administered prices and tax adjustments

Budget, current account and other balance of payments indicators

Output gap forecasts

Deterioration in pricing behavior and expectation formation

Pricing Behavior and Expectation Channel:

High levels of inflation may lead to a deterioration in pricing behavior, thereby strengthening backward-indexation.

Inflation and exchange rate expectations may give rise to a cycle of feeding each other, which may lead to weak anchoring of inflation expectations.

↑

↑

Core inflation indicators

Diffusion indices

Survey of Expectations

Stronger backward-indexation tendency in inflation expectations


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Weakening of capital flows towards emerging economies

Global Monetary Policies:

With inflation rising faster than anticipations, the Fed and ECB monetary policy tightening processes may evolve faster than expected. Accordingly, capital flows towards emerging economies may slow.

Global Risk Appetite:

Protectionist trade policies may trigger concerns over global growth and affect the global risk appetite adversely.

Concerns on debt dynamics of some EU countries are likely to constrain the global risk appetite.

↑

↑

↑

Global risk appetite indicators

The course and composition of global capital flows, Turkey's share

Developments in Turkish banks' borrowing costs

Developments in loans received from abroad by firms

Persistence of financial market volatility caused by domestic factors

Risk Premium:

Deterioration in risk perceptions towards Turkey due to the developments in current account and other factors that determine the risk premium or contagion effect that might arise from possible fluctuations in global financial markets may have an adverse impact on Turkey’s risk premium.

↑

Implied exchange rate volatilities

Risk premium indicators

Global risk appetite indicators

Exchange rates

Further supply-side tightening in bank loans

Balance Sheet Channel:

Banks may curb loan supply against the likelihood of financial difficulties that may be experienced by firms using FX loans due to fluctuations in financial markets. The increase in the number of insolvent firms may affect the country's risk premium negatively.

A significant deceleration in the rate of increase in house and commercial real estate prices may decrease the value of collaterals that the firms put up against loans, and firms may be exposed to tighter credit conditions.

Bank Lending Channel:

The decline in banks' CARs might affect credit supply adversely.

↔

↓

↓

Developments in loan growth with a breakdown by public and private banks

Developments in loan and deposit rates

NPL breakdown by sectors and loan types

Yield spread on corporate bond issues

Credit conditions (Bank Loans Tendency Survey)

Financial and corporate sector balance sheets, financial flows

House prices (nominal/real)

House sales, construction sector value added

Adverse effects of global protectionist trade policies on economic activity, trade volume and prices

Foreign Demand:

Protectionist trade policies may have a downward effect on the global growth outlook, primarily in the US and China. The fact that the above-mentioned additional customs tariff will also be implemented for European Union countries keeps the downward risks to the euro area economic activity alive. In such a case, a likely weakening in Turkey’s foreign demand might reduce capacity pressures on sectors.

Sectoral capacity pressures may be experienced if demand heads towards Turkey from countries exposed to protectionist measures in some sectors.

Global Inflation and Financial Conditions:

The monetary policy response to protectionism-driven inflation in related countries may tighten global financial conditions and lead to the depreciation of the Turkish lira.

Developments in protectionist trade policies

Export-weighted global economic activity index

Global trade volume and inflation developments

Data on sectoral activity and prices

Monetary policy response in advanced and emerging economies


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Rise in crude oil prices

Import Prices:

Crude oil prices may rise if OPEC’s decision to increase oil production fails to remedy a possible drop in oil production due to the resumed US embargo on Iran.

Heightened uncertainty due to geopolitical developments may spark upward speculative movements in crude oil prices in the short term.

Risks regarding the weakening global growth are likely to cause a downward effect on crude oil prices in the medium term.

↑

↑

↓

Crude oil prices

OPEC decisions

Arrangements on domestic fuel oil prices

Imports and current account balance

Ongoing rise in food prices

Unprocessed Food Prices:

Inflation expectations may be affected negatively due to a later-than-anticipated correction in unprocessed food prices that have recently soared relative to long-term trends.

↑

Developments in food prices by categories and sub-categories

Deviation of unprocessed food prices from historical trend

Food Committee measures and their implications

* Each risk row of the table presents evaluations on the channel through which inflation forecasts may change, along with the direction of that change, if the respective risk materializes. The signs ↑, ↓ indicate the direction in which the risks influence the inflation forecast (upside and downside, respectively). The sign ↔ denotes circumstances where the net effect on the inflation forecast is not clear. Indicators used in monitoring the risks are listed in the right column.


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Box 7.1

Interaction of Monetary and Fiscal Policies This box presents a number of interaction channels and improvement areas to enhance the coordination between monetary and fiscal policies. While fiscal policy has recently provided a short-term contribution to disinflation through administered prices and tax adjustments (Box 3.1), additional accommodative fiscal measures introduced since the end of 2017, when economic activity was robust, put upward pressure on inflation through other channels. The introduction of additional accommodative fiscal measures since the end of 2017 when economic activity was robust has affected inflation through various channels even though administered prices have been set by the government in an attempt to control inflation. The first channel is where expansionary fiscal policies boost aggregate demand through the government expenditure multiplier. With the output gap remaining in positive territory recently, the increase in aggregate demand seems to have pushed inflation higher. The risk premium is another channel through which expansionary fiscal policy influences inflation. Maintaining an expansionary fiscal policy stance when monetary policy tightens causes the country's risk premium to rise and creates more pressure on exchange rates in an environment of tight global financial conditions along with elevated inflation and widened current account deficit (Box 5.1). To contain these risks and bring inflation back on a downward path, it is critical to strengthen the ongoing coordination between monetary and fiscal policies with a view to macro balancing and to openly communicate the relevant steps to be taken.

On the whole, the coordination between public policies seems to play a determining role in the country's internal and external imbalances through economic activity and inflation. In Turkey, the challenges of high inflation and a wide current account deficit call for attention to the effects of any domestic demand-boosting fiscal measures on inflation and the external balance. Regarding disinflation, the coordination between monetary and fiscal policies does not just mean aligning the inflationary impact of administered prices with the inflation target. The size of the fiscal policy effect on aggregate demand and the stage of the economic cycle also play an important role in this context.

Some of the government's economic policies are more structural in nature, aimed at increasing the country's long-term potential growth rate, whereas others are more conjunctural, aimed at minimizing cyclical fluctuations in the economy. Fiscal policy can serve both purposes while monetary policy only helps reduce fluctuations around the long-term trend. Thus, to minimize macroeconomic fluctuations, monetary policy and fiscal policy have to be coordinated.

Cyclical fiscal policies and monetary policy aim to maximize household welfare by affecting macroeconomic fluctuations.1 Among observed variables, both the levels of inflation and output gap and their volatility (fluctuations) are influenced by these policies. The economic literature has studied how the objectives for which fiscal policy operates can also affect economic performance. For example, Büyükbaşaran, Çebi and Küçük Yeşil (2017) have found that incorporating inflation and output gap volatility into the design of fiscal policy delivers more successful results for the reduction of inflation and output gap volatility, relative to when only debt stability or output gap volatility is factored in. If both monetary and fiscal policies address the volatility in inflation and economic activity, two of the most fundamental indicators of macroeconomic stability, the costs associated with tradeoffs can be smaller and the policies in

1 Examples of studies that have explored the optimal monetary and fiscal policy combination to maximize social welfare include Chari and Kehoe (1999),

Schmitt-Grohe and Uribe (2004) and Benigno and Woodford (2003).

Medium Term Projections

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place can be more effective.

The first and most direct channel by which fiscal policy affects inflation is where expansionary fiscal policies boost aggregate demand through the government expenditure multiplier. Studies in the academic literature indicate that there are many determinants of an effective fiscal policy, and the state of the business cycle, the exchange rate regime, trade openness, the type of fiscal shocks, the size of automatic stabilizers, public fiscal stance, monetary policy actions, the soundness of the financial system and uncertainty can play a major role in determining the sign and size of the fiscal multiplier (Batini et al., 2014). There are also studies showing that the fiscal multiplier might be higher in countries with a lower debt level (Huidrom et al., 2016).

Thus, a conjunctural fiscal policy should be designed bearing in mind that fiscal multipliers may change in high or low growth episodes. Some studies in the academic literature have concluded that increased public spending might have a more substantial effect on GDP, particularly during periods of low growth/recession (Auerbach and Gorodnichenko, 2012, 2013; Baum and Koester, 2011; Çebi and Özdemir, 2016). Accordingly, in high growth episodes with a positive output gap and an economy showing signs of heating up, increased public spending will have smaller effects on growth but the resulting incurred cost (tax hike or debt increase) will rise. Therefore, it is important to use the existing fiscal space to revive economic activity and reduce unemployment rates in low growth episodes, and to curb government spending and restore budgetary discipline in high growth episodes. The fiscal discipline to be secured by cutting back on government spending is also believed to contribute to increasing domestic savings in countries with wide current account deficits.

The risk premium is another channel through which expansionary fiscal policy has a more indirect but a bigger potential impact on inflation. Charts 1 and 2 illustrate that despite the strong momentum achieved in the economy, the primary balance adjusted for the economic cycle that represents the discretionary component of the fiscal policy has been on the decline since 2016. In other words, in 2017, when the output gap was in positive territory (when the economic growth outperformed its potential), the fiscal policy remained accommodative. This situation pushed the country's risk premium to high levels by causing investors to question the coordination between public institutions in charge of achieving macroeconomic stability as it hampered the fight against inflation. In addition to such concerns, the onset of the deterioration in the current account deficit, budget deficits that started to present an unfavorable outlook despite being at manageable levels compared to peer economies, and exchange rate depreciation led by increasing risk premium have also been instrumental in pushing inflation up. As a matter of fact, Box 5.1 reveals that in times of tight financial conditions, deteriorations in components such as the current account balance, international reserves and budget balance cause Turkey's risk premium to diverge negatively from those of peer economies. Therefore, in addition to improving these components, communicating these developments in a more transparent and comparable fashion is considered important for management of expectations and control of risk perceptions.

There remain significant to-be-improved aspects in tax and spending policies to achieve fiscal policy implementation overseeing macroeconomic imbalances as well as debt stabilization, and to strengthen the coordination between monetary and fiscal policies. Regarding tax policies, a simpler and more efficient tax system, a more effective fight against unregistered economy and expansion of the tax base will substantially increase the income generation capacity of the government and will help increase the share of direct taxes in total tax revenues. Furthermore, consideration of predictability in the design of tax policies will affect spending and saving decisions of both public and private sectors positively.


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Given that tax revenues play an important role in funding government spending, it is essential to draw up an effective spending policy in addition to an effective tax policy. Besides, as the composition of government spending is also one of the determinants of macroeconomic equilibrium, increasing the efficiency in government spending and channeling public investments towards sectors that will boost the potential production capacity in the long run will contribute to social welfare. Finally, communication of the fiscal policy implementation to the public is important due to its effects on expectations management and the country's risk premium.

Chart 1: Output Gap (Average and Minimum/Maximum Band)

Chart 2: Cyclically-Adjusted Primary Budget Balance (Percentage of Potential GDP, %)

Source: CBRT calculations. Sources: Ministry of Finance, CBRT calculations.

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-10

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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 18

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Primary Balance/ GDP

Cyclically Adjusted Primary Balance / Potential GDP

Medium Term Projections

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Reference

Auerbach, Alan J., and Yuriy Gorodnichenko (2012), “Measuring the Output Responses to Fiscal Policy”, American Economic Journal: Economic Policy, 4, no. 2: 1-27.

Auerbach, Alan J., and Yuriy Gorodnichenko (2013), “Fiscal Multipliers in Recession and Expansion”, In Fiscal Policy after the Financial Crisis, eds. A. Alesina and F. Giavazzi, 63-98. Chicago: University of Chicago Press.

Batini, Nicoletta, Luc Eyraud and Anke Weber (2014), “A Simple Method to Compute Fiscal Multipliers”, IMF Working Paper, 14/93.

Baum, Anja, and Gerrit B. Koester (2011), “The Impact of Fiscal Policy on Economic Activity over the Business Cycle - Evidence from a Threshold VAR Analysis”, Deutsche Bundesbank Discussion Paper, no. 03/2011.

Benigno, Pierpaolo, and Michael Woodford (2003), “Optimal Monetary and Fiscal Policy: A Linear-Quadratic Approach”, NBER Macroeconomics Annual, 18: 271-333.

Büyükbaşaran, Tayyar, Cem Çebi and Hande Küçük Yeşil (2017), “The Interaction between Monetary and Fiscal Policies in a Small Scale Structural Model”, CBRT Research Notes in Economics, under review.

Chari, Varadarajan V., and Patrick J. Kehoe (1999), “Optimal Fiscal and Monetary Policy”, Handbook of Macroeconomics, 1: 1671-1745.

Çebi, Cem and K. Azim Özdemir (2016), “Cyclical Variation of Fiscal Multiplier in Turkey”, CBRT Working Paper No. 16/19, September 2016.

Huidrom, R., Kose, M.A., Lim, J. and F. Ohnsorge (2016), “Do Fiscal Multipliers Depend on Fiscal Positions?”, CEPR Discussion Paper, DP11346.

Schmitt-Grohé, Stephanie, and Martın Uribe (2004), “Optimal Fiscal and Monetary Policy under Sticky Prices”, Journal of Economic Theory, 114.2: 198-230.


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Charts 1. OVERVIEW

Chart 1.1 Global Growth Rates 1 Chart 1.2 Portfolio Flows to Emerging Economies 1 Chart 1.1.1 Short-Term Interest Rates 2 Chart 1.1.2 CBRT Funding 2 Chart 1.1.3 Swap Yield Curve 3 Chart 1.1.4 Implied FX Volatility 3 Chart 1.1.5 Annual Loan Growth 3 Chart 1.1.6 Contributions to FCI 3 Chart 1.2.1 April Inflation Forecast and Actual Inflation 4 Chart 1.2.2 Forecast and Actual Inflation Rates for Inflation excl. Unprocessed Food, Alcoholic Beverages

and Tobacco Products 4

Chart 1.2.3 Prices of Core Goods and Services 5 Chart 1.2.4 Diffusion of B and C Indices 5 Chart 1.2.5 GDP and Domestic Demand 5 Chart 1.2.6 Contributions to Annual GDP Growth from the Expenditures Side 5 Chart 1.2.7 Unemployment Rates 6 Chart 1.2.8 Current Account Balance 6 Chart 1.2.9 Revisions in Oil Price Assumptions 7 Chart 1.2.10 Revisions in Import Price Assumptions 7 Chart 1.3.1 Inflation and Output Gap Forecasts 8

2. INTERNATIONAL ECONOMIC DEVELOPMENTS

Chart 2.1.1 Global Growth Rates 12 Chart 2.1.2 Regional Growth Rates for Emerging Economies 12

Chart 2.1.3 Global PMI 12 Chart 2.1.4 Manufacturing Industry PMI in Advanced Economies 12 Chart 2.1.5 Emerging Markets PMI 13 Chart 2.1.6 Export-Weighted Global Production Index 13 Chart 2.2.1 S&P Goldman Sachs Commodity Index 15 Chart 2.2.2 Brent Crude Oil Prices 15 Chart 2.2.3 CPI Inflation in Advanced and Emerging Economies 15 Chart 2.2.4 Core Inflation in Advanced and Emerging Economies 15 Chart 2.3.1 Policy Rate Changes and Year-end Policy Rate Expectations in Advanced Economies 17 Chart 2.3.2 Policy Rate Changes and Year-end Policy Rate Expectations in Emerging Economies 17 Chart 2.4.1 10-Year Bond Yields 18 Chart 2.4.2 MSCI Indices 18 Chart 2.4.3 JP Morgan FX Volatility Indices 19

Chart 2.4.4 Weekly Fund Flows to Emerging Economies 19

3. INFLATION DEVELOPMENTS

Chart 3.1 CPI and D Index 25 Chart 3.2 Contributions to Annual CPI 25 Chart 3.1.1 Prices of Core Goods and Services 26 Chart 3.1.2 Core Goods Prices 26 Chart 3.1.3 Selected Durable Consumption Goods Prices 28 Chart 3.1.4 Core Goods Prices 28 Chart 3.1.5 Prices of Services by Sub-Categories 28 Chart 3.1.6 Accommodation Services and Tourism Revenues 28 Chart 3.1.7 Other Services and Currency Basket 29 Chart 3.1.8 Transport Services and Fuel Prices 29 Chart 3.1.9 Services Prices 29 Chart 3.1.10 Diffusion Index for Services Prices 29 Chart 3.1.11 B and C Diffusion Indices 30 Chart 3.1.12 B and C Diffusion Indices 30 Chart 3.1.13 B and C Diffusion Indices 30 Chart 3.1.14 Core Inflation Indicators SATRIM* and Median 30

Charts

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Chart 3.2.1 Food and Energy Prices 31 Chart 3.2.2 Food Prices 31 Chart 3.2.3 Food Excl. Fresh Fruits and Vegetables 31 Chart 3.2.4 Selected Food Prices 31 Chart 3.2.5 Oil and Selected Domestic Energy Prices 32 Chart 3.2.6 Domestic Energy Prices 32 Chart 3.3.1 Domestic Producer and Consumer Prices 33 Chart 3.3.2 Manufacturing Prices 33 Chart 3.3.3 Import Prices in USD and TL 34 Chart 3.3.4 Manufacturing Prices Excluding Petroleum and Base Metal Products 34 Chart 3.4.1 Prices of Agricultural Products and Food 35 Chart 3.4.2 Prices of Agricultural Products and Food 35 Chart 3.4.3 Onion Prices 35 Chart 3.4.4 Potato Prices 35 Chart 3.5.1 CPI Inflation Expectations 36 Chart 3.5.2 Medium-Term Inflation Expectations Curve 36 Chart 3.5.3 Probability Distribution of 12-Month-Ahead Inflation Expectations 36 Chart 3.5.4 Probability Distribution of 24-Month-Ahead Inflation Expectations 36

4. SUPPLY AND DEMAND DEVELOPMENTS

Chart 4.1.1 Contributions to Y-o-Y GDP Growth from the Production Side 43 Chart 4.1.2 Contributions to Quarterly GDP Growth from the Production Side 43 Chart 4.1.3 Industrial Production Index 44 Chart 4.1.4 PMI and PMI Production 44 Chart 4.1.5 Construction Sector Value Added and Composite Index 44 Chart 4.1.6 Services Sector Activity and Value Added 44 Chart 4.2.1 Contributions to Y-o-Y Growth from the Expenditure Side 45 Chart 4.2.2 Contributions to Quarterly GDP Growth from the Expenditure Side 45 Chart 4.2.3 Private Consumption and Composite Indicator for Private Consumption 46 Chart 4.2.4 Automobile and White Goods Sales 46 Chart 4.2.5 Investment Expenditures and Composite Indicator for Investment Expenditures 46 Chart 4.2.6 Fixed Capital Investment Tendency by Sectors Based on BTS 46 Chart 4.2.7 Quantity Indices for Imports and Exports 47 Chart 4.2.8 Tourism and Services Revenues 47 Chart 4.3.1 Unemployment and Labor Force Participation Rates 48 Chart 4.3.2 Contributions to Quarterly Changes in Non-Farm Unemployment 48 Chart 4.3.3 Non-Farm and Services Employment 48 Chart 4.3.4 Industrial and Construction Employment 48 Chart 4.3.5 BTS Employment Expectation by Sectors for the Next 3 Months 49 Chart 4.3.6 Employment in Selected Services Subsectors 49 Chart 4.3.7 Employment in Selected Services Subsectors 49 Chart 4.3.8 PMI and Manufacturing Industry Employment 49 Chart 4.3.9 Expected Number of Employees by Sectors for the Next 3 Months 50 Chart 4.3.10 Total Number of Job Posts, Applications per Job Post, and Non-Farm Unemployment Rate 50 Chart 4.4.1 Non-Farm Nominal Earnings Index and Net Minimum Wage 51 Chart 4.4.2 Non-Farm Partial Labor Productivity*, Per Person Real Wage and Real Unit Wage 51 Chart 4.4.3 Non-Farm Hourly Earnings Index 51 Chart 4.4.4 Real Unit Labor Cost by Sectors 51 Chart 4.5.1 Alternative Output Gap Indicators 52 Chart 4.5.2 Output Gap 52


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5. FINANCIAL CONDITIONS AND MONETARY POLICY

Chart 5.1 Financial Conditions and Credit Growth 63 Chart 5.2 Contributions to FCI 63 Chart 5.1.1 Regional Risk Premium 64 Chart 5.1.2 Cumulative Portfolio Flows to Turkey 64 Chart 5.1.3 Turkish Lira and Emerging Market Currencies against US Dollar 65 Chart 5.1.4 Implied FX Volatility against US Dollar 65 Chart 5.1.5 6-Month Market Rates 65 Chart 5.1.6 5-Year Market Rates 65 Chart 5.2.1 Indicators on Banks’ Funding Costs 66 Chart 5.2.2 TL Commercial Loan Rates and TL Deposit Rates 66 Chart 5.2.3 TL Commercial Loan Rates 66 Chart 5.2.4 Consumer Loan Rates 66 Chart 5.2.5 Domestic Credit Stock and Net Credit Use 67 Chart 5.2.6 Annual Loan Growth 67 Chart 5.2.7 Annualized Total Loan Growth 67 Chart 5.2.8 Annualized Commercial Loan Growth 67 Chart 5.2.9 Annualized TL and FX Commercial Loan Growth 68 Chart 5.2.10 Annualized Consumer Loan Growth 68 Chart 5.2.11 Commercial Loan Standards and Commercial Loan Demand 69 Chart 5.2.12 Consumer Loan Standards and Consumer Loan Demand 69 Chart 5.3.1 CBRT Funding 70 Chart 5.3.2 Short-Term Interest Rates 70 Chart 5.3.3 Swap Yield Curve 70 Chart 5.3.4 Yield Curve Slopes in Emerging Economies 70 Chart 5.3.5 Inflation Compensation 71 Chart 5.3.6 Distribution of 24-Month-Ahead Inflation Expectations 71 Chart 5.3.7 2-Year Bond Yields and the Real Interest Rate in Turkey 71

6. PUBLIC FINANCE

Chart 6.1.1 Central Government Budget Balance 78 Chart 6.1.2 Central Government Budget Revenues and Primary Expenditures 78 Chart 6.1.3 Real Tax Revenues 80 Chart 6.1.4 Real VAT and SCT Revenues 80 Chart 6.2.1 Public Debt Stock Indicators 80 Chart 6.2.2 Composition of the Central Government Debt Stock 80 Chart 6.2.3 Average Maturity of Domestic Cash Borrowing and the Average Term-to-Maturity of the

Domestic Debt Stock 81

Chart 6.2.4 External Borrowing through Bond Issues 81 Chart 6.2.5 Total Domestic Debt Rollover Ratio 81 Chart 6.2.6 Treasury Auctions Interest Rate and Maturity Structure 81

7. MEDIUM-TERM PROJECTIONS

Chart 7.1.1 Export-Weighted Global Production Index 84 Chart 7.1.2 Revisions to Oil Price Assumptions 85 Chart 7.1.3 Revisions to Import Price Assumptions 85 Chart 7.1.4 Month US Bond Rates 85 Chart 7.2.1 Inflation and Output Gap Forecasts 87 Chart 7.2.2 Inflation Forecast 88 Chart 7.2.3 Output Gap Forecast 88 Chart 7.2.4 Forecast of Inflation Excluding Unprocessed Food, Alcoholic Beverages and Tobacco Products 89

Tables

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Tables 2. INTERNATIONAL ECONOMIC DEVELOPMENTS

Table 2.1.1 Growth Forecasts for 2018 and 2019 14 Table 2.2.1 Inflation Forecasts for end-2018 and end-2019 16 Table 2.4.1 Composition and Regional Distribution of Fund Flows to Emerging

Economies 19

3. INFLATION DEVELOPMENTS

Table 3.1.1 Prices of Goods and Services 27 Table 3.3.1 D-PPI and Sub-Categories 33

6. PUBLIC FINANCE

Table 6.1.1 Central Government Budget 77 Table 6.1.2 Central Government Primary Expenditures 79 Table 6.1.3 Central Government General Budget Revenues 79 7. MEDIUM-TERM PROJECTIONS

Table 7.1.1 Changes in Key Forecast Variables 83 Table 7.1.2 Revisions to Assumptions 86 Table 7.2.1 CBRT Inflation Forecasts and Expectations 89 Table 7.3.1 Key Risks to Inflation Forecasts and Possible Impact Channels 91


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Boxes in Previous Inflation Reports 2018-I

2.1 Possible Effects of the US Tax Reform

3.1 A Look at Core Inflation DynamicsEffects

4.1 Import Dynamics in 2017: The Weak Course of Investment and Consumption Goods 5.1 Effectiveness of the CBRT on Money Market Rates 5.2 Recent Developments in Turkish Lira-Settled Forward Foreign Exchange Sale Auctions 6.1 Distribution of Domestic Debt Instruments by Investor Type 7.1 An Evaluation of End-2017 Inflation Forecasts 2017-IV

2.1 The Fed Balance Sheet Unwind and its Possible Effects

3.1 Pass-Through from Producer Prices to Consumer Prices

4.1 Real Improvement in Turkey’s Current Account Deficit

4.2 Extending the Coverage of the Real Effective Exchange Rate Index Based on Unit Labor Cost

4.3 Capacity Utilization Rate in Manufacturing and the Implications for Investment

5.1 The Role of the Credit Channel in Monetary Policy Transmission: A Survey-Based Analysis of Turkey

2017-III

2.1 The Expanded Coverage of the Export-Weighted Global Growth Index Changes in Inflation Dynamics

3.1 Recent Developments in Food Prices 4.1 GDP Forecasts with New National Income Series 4.2 The Resilience of Turkish Exports to Foreign Demand Shocks: The Case of Fresh Fruits and

Vegetables 5.1 The Transmission of Monetary Policy to Swap Market Rates 6.1 Effects of Foreign Investors’ Share on the Long-Term Borrowing Rate 7.1 Macroeconomic Effects of the Changes in Credit Supply 2017-II

3.1 Changes in Inflation Dynamics

3.2 Changes in the Weighting Scheme of Clothing and Footwear

4.1 The Recent Acceleration in Automotive Exports and the EU Export Demand

5.1 Foreign Exchange Deposits Against Turkish Lira Deposits Market Transactions

6.1 Cyclical Features of Tax Revenues in Turkey

7.1 Identifying the Credit Channel Through a Structural Model

2017-I

2.1 Recent Global Uncertainties and Its Implications 3.1 Pass-Through from Import Prices and Exchange Rate to CPI and Subcategories 4.1 An Economic Uncertainty Indicator for Turkey 4.2 Alternative Indicators for Output Gap 4.3 The Weakening Real External Trade Deficit-GDP Relationship and Loan Growth 5.1 Open Market Operations, Portfolio Size of Securities and Outright Purchasing Transactions 6.1 The Sensitivity of Fiscal Multiplier to Business Cycles 7.1 An Evaluation of end-2016 Inflation Forecasts 2016-IV

3.1 Inflation Dynamics over the Past Decade: A Historical Accounting 3.2 The Impact of the Tourism Slump on Food Inflation 4.1 Effects of Tourism on Main Macroeconomic Aggregates 4.2 Assessing Turkey’s Export Gain in the EU Market in Terms of Competitiveness 4.3 The Impact of Agricultural Banking on Agricultural Productivity 5.1 The Collateral FX Deposit Facility and Its Impact on Currency Swap Markets 5.2 Recent Loan Developments: Some Indicators on Loan Supply and Demand 6.1 Main Features of the Recent Incentive Schemes in Turkey

Abbreviations

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Abbreviations A-PPI Agricultural Producer Price Index

AMA Automobile Manufacturers Association

bbl Barrel

BIST Borsa İstanbul

BTS Business Tendency Survey

CBRT Central Bank of the Republic of Turkey

CGF Credit Guarantee Fund

CPI Consumer Price Index

D-PPI Domestic Producer Price Index

ECB European Central Bank

EMBI Emerging Markets Bond Index

EPFR Emerging Portfolio Fund Research

EU European Union

EUR Euro

FCI Financial Conditions Index

FOMC Federal Open Markets Committee

Fed Federal Reserve Bank

FX Foreign Exchange

G20 The Group of Twenty

GDP Gross Domestic Product

IHS Information Handling Services

IMF International Monetary Fund

JPMVXEM JPMorgan Emerging Market Volatility Index

JPMVXG7 JPMorgan G7 Volatility Index

LLW Late Liquidity Window

MEDIAN Median Inflation for Seasonally Adjusted 5-Digit Sub-Price Index

MSCI Morgan Stanley Capital International

MTP Medium-Term Program

OECD Organization for Economic Cooperation and Development

OMO Open Market Operations

OPEC Organization of the Petroleum Exporting Countries

PMI Purchasing Managers Index

PPI Producer Price Index

PTT The National Post and Telegraph Directorate of Turkey

Q-o-Q Quarter-on-quarter

S&P Standard and Poor’s

SATRIM Seasonally Adjusted Trimmed Mean Inflation

SCT Special Consumption Tax

SME Small and Medium-Sized Enterprises

SMEs Small and Medium-Sized Enterprises

SSI Social Security Institution

TCDD The State Railways of the Turkish Republic

TL Turkish Lira

TRY Turkish Lira

TURKSTAT Turkish Statistical Institute

UK United Kingdom

ULC Unit Labor Cost

US United States

USA United States of America

USD United States Dollar

VAT Value Added Tax


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VIX Volatility Index

WGMA White Goods Manufacturers Association

Y-o-Y Year-on-year

Calendar

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2018 Calendar for MPC Meetings, Inflation Report and Financial Stability Report

MPC Meetings Summary of the MPC

Meeting Inflation Report Financial Stability Report

18 January 2018 25 January 2018 30 January 2018

7 March 2018 14 March 2018

25 April 2018 30 April 2018 30 April 2018

31 May 2018

7 June 2018 14 June2018

24 July 2018 31 July 2018 31 July 2018

13 September 2018 20 September 2018

25 October 2018 31 October 2018 31 October 2018

30 November 2018

13 December 2018 20 December 2018

Inflation Report - TCMB

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