EMRE DELİVELİ >Markets getting ahead of the Central Bank

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One of the leading Turkish economy themes of this past week was the large decline in government bond yields. 

After falling from 9.45 to 8.85 percent in June, the benchmark government bond finished the week at just above 8 percent on Friday. According to Bloomberg, remarks from Central Bank Governor Erdem Başçı that the Bank might revise down its inflation forecast had already triggered speculation that the policy rate might be cut. 

Markets got what they wanted last week, as the Central Bank lowered the average funding rate of banks, which is the effective policy rate, to 8.20 percent on Friday from 9.02 percent the week before by lending to banks at the one-week repo rate of 5.75 percent throughout the week. Markets were also responding to June inflation. At 8.9 percent, yearly inflation turned out to be much lower than expectations of 9.5 percent. 

The key question is whether this easing will continue. The answer is important not only for
Mrs. Watanabe the Japanese housewife and the Mayfair hedge fund manager, saving for retirement and an Aston Martin respectively, but also for most of my readers, as lower rates will weaken the lira, which so far has held up well. 

Markets seem to be expecting more of the same. Not only did their year-end inflation expectations fall sharply, growth dynamics seem to support lower rates. While first quarter growth,
at3.2 percent yearly, came in better than expected, domestic demand was very weak, and the most recent leading indicators are hinting that economic activity may not pick up during the second half of the year, as widely expected. 

There is also the expectation that
Thursday’s actions by the European Central Bank, the People’s Bank of China and the Bank of England may tempt the Central Bank of Turkey to go ahead with its own easing as well. I beg to disagree. After falling behind for a long time, markets may now be getting ahead of the Central Bank. 

For one thing, the mild inflation turnout was mainly due to the recent fall in oil prices and favorable food inflation. Oil prices are creeping up again because of
Iran-related political worries. Turkish food prices are notoriously volatile and subject to sharp reversals, as a recent Citi research note underlines. Actually, the Bank made these points at their most recent meetings with economists.

Başçı is probably not too happy with the market's expectation that interest rates will be lowered further, as it may weaken the lira.  
During a speech on Friday, he emphasized that a downward revision of the Bank’s end-year inflation forecast of 6.5 percent would not lead to easing. The Bank seems to prefer bringing inflation as close as possible to the 5 percent inflation target instead.

Finally, despite the recent improvements in the current account, the balance of payments picture remains challenging. Unless capital inflows, which have so far remained low relative to the current account deficit, pick up in the second half of the year, the Bank will not have much room to ease without hurting market sentiment and putting pressure on the lira.

To sum up, the hedge fund manager’s Aston Martin, as well as your and Mrs. Watanabe’s lira savings, seem to be safe for now.


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