Is the inflation forecast overly optimistic?
Things are going well for now, after the Central Bank’s interest rate cut, which was well above expectations. Turkish assets continue to be at premium while the TRY is gaining value. The TRY has gained more than three percent in value in the last two weeks, while 10-year government bonds have fallen by more than 100 basis points. Of course, the change in the global economic outlook and the return of the central banks in all developed countries, especially the Fed, have an important effect on this positive course.
Under normal circumstances, the discount could have been more cautious. However, as stated in the decision text, “domestic demand developments and the support of monetary tightening for reducing inflation” seem to have led
to a higher reduction than expected. As a matter of fact, the third Inflation Report of the year, published a week later, indicated that the main indicators of inflation, supply-based factors and import prices positively affected the inflation outlook. According to the report, “depending on these developments, current forecasts indicate that inflation for the end of the year may be slightly below the forecasts made in the April Inflation Report.” As a result, the Central Bank reduced the 2019 yearend consumer inflation forecast to 13.9 percent from 14.6 percent in the April report.
The Central Bank needs to pay particular attention to two issues in addition to many variables when making inflation forecasts. First, the outlook of the future interest rate path, in other words, monetary policy decisions to be taken by the Central Bank itself have an impact on future inflation rates. It is clear that the governor, who is in search of a reasonable real interest rate, will continue to cut rates under normal conditions and this will create an acceleration in credit volume, which has slowed down considerably recently. However, if this acceleration is higher than expected, the extent to which credit growth will affect the real economy, as well as prices, should be integrated into the model. Frankly, I’m not sure this is the case.
The second point is that when estimating inflation, the public sector’s deficits that are no longer sustainable and the adjustments in managed and guided product prices, which are the most effective measures to narrow these deficits in the short term (public hikes in short), need to be predicted in a realistic way. In recent weeks, there have been a series of hikes. Again, I am not sure that this has been sufficiently taken into account in the Inflation Report. In fact, this is not even included in the Sources of Forecast Update table. It is quite optimistic that the measures to control the budget deficit, which has worsened significantly compared to the conditions prevailing in the April Inflation Report, will not have an “additional” impact on inflation in the second half of the year.
As a result, I find the Central Bank’s 13.9 percent year-end CPI forecast to be extremely optimistic, and I believe that aggressive interest rate cuts on this forecast may be risky.