5 Currency swings are an additional source of risk. Policy and Market Rates (Percent) 12 16 20 24 28 32 Jan-05 Jun-05 Nov-05 Apr-06 Oct-06 Mar-07 12 16 20 24 28 32 One-year money market rate Overnight lending policy rate Overnight borrowing policy rate Sources: Central Bank of Turkey; and Bloomberg. 5 While there is still some uncertainty on the strength of the monetary transmission mechanism, financial deepening appears to be bolstering the bank liquidity channel (see SIP). Inflation: Actual, Targets, and CBT Forecast (Percent) 0 2 4 6 8 10 12 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 0 2 4 6 8 10 12 Upper fan limit Lower fan limit Targets/uncertainty bands 5.3 4.0 6.7 9.2 Sources: Central Bank of Turkey; and IMF staff calculations and estimates. Inflation Expectations (Percent) 4 6 8 10 Jan-05 Jun-05 Dec-05 May-06 Nov-06 Apr-07 4 6 8 10 24 months ahead 12 months ahead Source: Central Bank of Turkey.
26 31. There is, therefore, little alternative to keeping monetary policy tight in the near term . The level of interest rates is appropriate, as is the central bank’s tightening bias: positive surprises about the inflation outlook should elicit no policy response, but negative news should defer rate cuts or even lead to rate hike s. In this regard, the central bank noted that a sudden reacceleration of credit growth would be a warning sign that the medium-term target is at risk. 32. Staff and the authorities concurred that, once inflation is on a firm downward trend, interest rates could be cautiously reduced . Timing the start of the easing cycle is a difficult task. The central bank stressed that the central scenario of beginning rate cuts in the fourth quarter of 2007 is not a commitment, but a conditional statement. In the absence of suitable leading indicators of inflationary pressures (wage data, for instance, are released with significant lags) and in view of the predominantly backward-looking inflation expectations, the central bank will focus on trends in actual inflation. Specifically, a declining path of services inflation would suggest that inflationary pressures are subsiding and that a gradual monetary easing could start. 33. Preserving central bank independence and continuing to enhance the monetary policy framework are crucial for securing low inflation . Before adopting formal inflation targeting (IT) in January 2006, the central bank increased the transparency and accountability of its monetary policy operations by making the timing of interest rate decisions predictable, assigning responsibility for setting rates to the monetary policy committee, and announcing issuance of a quarterly Inflation Report with medium-term inflation projections. The new IT framework, however, quickly faced challenges, as a sharp depreciation of the lira and a series of supply shocks led to a large breach of the inflation target. So long as inflation remains above target, the central bank should keep explaining the reasons for the deviations, presenting a realistic disinflation trajectory, and communicating policy intentions clearly. Regarding