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New economy perspective and monetary policy conventionality


It is understood that in the new economic period, low lira interest rates will be adopted, and it is aimed to reduce inflation with price stability to be achieved through exports and current account balance. President Mr. Recep Tayyip Erdogan’s economic perspective is that high interest rates feed inflation. In line with the new economy approach, the Central Bank has also reduced the benchmark interest rate by 22 points below the inflation rate with a series of rate cuts since September. Since the policy perspective applied is not at a traditional point, it is difficult to predict how far the rate cuts can go. Within the framework of the new economic perspective, the demand for the Central Bank to ease the monetary policy constitutes the main point in terms of the growth profile desired to be achieved in the economy. Therefore, at this stage, although exchange rate volatility feeds inflation, a U-turn effect is not expected yet. Nor do we expect a sudden policy change until the results of the new economic perspective are seen in a few months.


We do not find the dovish perspective of the Central Bank beneficial in terms of lira volatility. The low policy clarity in question caused the lira to be exposed to irrational volatility levels for a certain period of time. This situation caused extreme deviations in inflation and annual inflation reached 36.1% in December 2021. We expect this rate to continue to rise for a significant part of 2021, and a limited base effect will materialize towards the end of the year, yet inflation will remain high.


After the rate cut on December 16, the Central Bank may wait for a certain period of time. The Central Bank has recently abandoned its tightening policy, has not applied interest on inflation and has followed a loose interest policy that adapts to the transition to heterodoxy. It is seen that the basic motto in economic management is based on an empirical basis by moving away from the harmony of policy interest and inflation. We think that the Central Bank should make a comprehensive policy assessment. If rate cuts continue in a high inflation environment, they will have an increasing effect on exchange rate, inflation and market-based borrowing costs. It would be useful to keep the estimation range of these variables wide.


It is necessary to pay attention to the USDTRY rate, as it constitutes almost all financial elements in the economy. When the risks in the market are active and we see the effects of this on the volatility levels of the exchange rate, it can be expected that side policy instruments will be used to limit the foreign exchange demand. In this respect, although we will monitor the effect of the transition to the exchange-protected TRY deposit product, we expect the transition to be limited within the framework of negative TRY real returns, the functions of foreign exchange in the incentive to protect against high inflation, and the tendency of institutions to hold foreign currency to cover their imports. Before the Central Bank’s interest rate hike; By evaluating lateral instruments, we can expect it to bring similar applications to previous currency shocks. Based on the new macroeconomic and financial foundations that will emerge, the Central Bank may be forced to increase interest rates under the conditions that will occur in the future. We evaluate the current policy ground as looser than it should be compared to economic criteria, especially inflation.


Spillover Effect and Volatility Factor in Inflation


We expect an acceleration in inflation in the coming period. Turkey has been easing policy for a while by implementing a low interest policy despite rising inflation, but we see the consequences of this as more pressure on high inflation and rising borrowing costs. However, the fact that price stability is put into the background with the new economic perspective and the main policy tool is not used as an answer shows that policies far from orthodoxy will continue to be followed. These dynamics may lead to further depreciation of the lira and thus higher inflation.


The deterioration in inflation expectations is accelerating gradually. The volatility and stickiness in pricing due to the factors created by the recent economic turmoil cause the level of inflation to solidify. Given the current USDTRY levels and divergences, the continued upward trend in inflation is to be expected for the first part of the year. Putting price stability into the background with the new economic perspective and not using the main policy tool as an answer shows that policies far from orthodoxy will continue to be followed.


The CBRT defines inflation as temporary and evaluates that it is mainly driven by external factors such as energy prices. Inflation; We expect it to continue to increase due to global price trends and import cost underwriting stemming from the rise in the exchange rate. We expect consumer inflation, which we expect to remain high for most of the year, to decline partially due to the base effect in the last months of the year.


Along with the rapid effects on intermediate goods and energy prices, we expect the upward pressure on producer inflation to continue. High cyclical realizations late in the past year may ease the pressure on PPI at the end of the year if global supply shortages also ease and the pressure on intermediate goods costs is eased. However, we still consider imported input and energy costs stemming from the exchange rate as the biggest obstacles to easing.


Two Main Actors of the New Economy Perspective: Growth and Current Balance


We foresee lower projections in growth expectations compared to this year. We have reservations that placing the growth-oriented new economy perspective applications on a ground other than the market economy will cause some problems. We group these risks primarily in terms of inflation and decreasing purchasing power and increasing commercial risks. Demand shocks may occur in private consumption due to decreasing purchasing power as a result of increased inflation.


We do not see tighter financial conditions as positive in terms of growth, due to the increased exchange rate volatility, the continued depreciation of the lira, the increase in bond yields and CDS risk premiums, the increase in foreign portfolio outflows and the resulting rising borrowing costs due to the recent unconventional policies aimed at easing financial conditions. In order to keep these volatilities under control, measures are taken in terms of lateral policy instruments, especially the FX-protected TRY deposit product. At this point, we expect that practices such as facilitating credit conditions and a broad fiscal policy ground will continue in the implementation of growth-oriented policies. Since we think that the risk balance on growth is on the downside, we make moderate projections of 4.1% and 4% for 2022 and 2023, respectively.


In the current account balance, we will see the results of the practices in the field of the new economy perspective, which the economy administration has put into practice to increase exports. In this regard, we would like you to know that we have drawn attention to negative risks such as risks related to the outlook for foreign demand in exports and increased energy bills in imports. The improvement in the 2021 profile was due to the decrease in the effects of the epidemic and the strong outlook in exports and tourism. In imports, the slowdown in consumption-based imports and the neutralization of gold imports last year eased the pressure. However, the increase in energy costs on the import side neutralized this positive effect. With the current account balance realized in the last month of the year, we estimate that it will close the year 2021 with a total deficit of 16 billion dollars. This corresponds to about 2.1% of GDP. According to the market’s current account balance projections, our expectations for 2022 and beyond are more moderate. The main reason for this is; Energy costs are likely to remain high as a result of the effects of the sharp depreciation of the lira. We think that loose monetary and fiscal policies to be implemented in order to make the credit mechanism work and support growth will further increase the depreciation of the lira.


Public Finance, Banking Sector, Capital Buffers of Banks


We see that the budget data in 2021 is more positive than last year. This significant improvement in the budget performance was mainly due to the positive impact of import and consumption taxes on revenues. Government expenditures and financial supports may be at the forefront in order to maintain the 5-5.5 % band envisaged in the MTP in the coming years in the growth path. Increased economic activity will likely support an increase in direct taxes and corporate taxes. As for the SCT and VAT revenues from consumption, the continued depreciation of the lira, on the other hand, feeds inflationary expectations, and the impact of the demand is seen. On the income side, we see the contribution of debt restructuring revenues transferred from last year’s pandemic period this year.


We will continue to monitor the impact of the austerity measures taken in the public sector on budget expenditures, especially in terms of purchases of goods and services. The way and degree of use of government expenditures in growth targets will be directly related to the realization of the budget targets. We think that fiscal policy can still be active at this point. Interest expenses, on the other hand, can be a suppressive factor, especially in the context of increasing borrowing costs. For this reason, we follow the Treasury’s strategy to reduce foreign currency borrowing, especially on the domestic borrowing side. Our expectation is that the budget deficit/GDP ratio will be 3.6% this year and 3.5% next year, and the ratio of the budget deficit to national income will decrease to 2.9% by 2024.


The capital adequacy of Turkish banks remains at standard levels. According to the sector data for November, CAR is 18% and core CAR is 13%. For state banks, there are 15% and 11% core CAR levels. Core rates are down from 15% last year to 13%. In a comparison of public and private banks, private banks seem to be in a better position in terms of liquidity buffers and asset-liability management against financial risks, primarily from lira. On the public banks side, we follow the cycle of capital injections and low-interest loans promoted by the government.


Among the factors affecting profitability, it is seen that the increase in loan provisions is especially important. While loan growth continues, the dynamism in consumer loans continues as the driving force. The expansion in banking revenues and loan deposit margin is positive for the sector. In November, there was a high increase of 215% in provisions. With the increase in the total cost of credit risk, banks can be expected to increase their provisions in an environment where commercial loans are aimed to be increased with basic policy financial instruments and precautionary measures. We think that the current situation may have a limiting effect on banking profits.


Market-based borrowing costs are the most important factor in keeping loan rates low despite interest rate cuts. As a result, we follow a benchmark interest rate of 23% against an average funding rate of 14%. High realizations in inflation expectations in the coming months may increase market-based interest rates. This shows that the easing in loan rates may be limited. On the other hand, the increase in current interest rates by banks after the introduction of the new currency protected deposit product basically caused interbank interest rates to remain high in the current period. It can be expected that the decreasing risk appetite and the high course of loan interest rates will limit loan outflows in the sector. In the future, it will be necessary to look at the profit potential of core banking activity and the trend in interest margins.


Dollarization Phenomenon, Measures to Protect TRY, CBRT Reserves


We expect the dollarization trend to continue due to negative real TRY deposit returns, deteriorating inflation expectations and the incentive to store value against it. Since inflation is likely to rise above 40-50% in a few months, the TRY real interest rate, which is currently -22.1%, is expected to go towards minus 30-40. For this reason, it would be normal for the general tendency of depositors to be dominant on the side of foreign currency deposits. The ratio of foreign currency deposits in total deposits is around 62%. In the coming period, we will pay attention to the phenomenon of transition from foreign currency to TRY in terms of the impact of new exchange-protected deposit products. We care about how much money is converted from FX to TRY as much as the opening of currency-protected accounts. On the other hand, we will monitor the movement of total deposits in terms of the fact that money remains in the financial system, that is, the phenomenon of financial stability.


We still see foreign currency deposits as the main form of valuation of savings. With the foreign currency protected TRY deposit product, which was issued as a tool other than Orthodoxy, the depreciation of TRY is desired to be controlled. The said measure guarantees the depositors’ foreign exchange losses if the increase in foreign currency is higher than the bank’s interest rates in the relevant term. In this instrument, which is outside of the monetary policy orthodoxy, the guarantee offered by the Treasury will increase the borrowing requirement since it will increase the FX-derived liabilities if the foreign exchange movement is above the predicted levels. Net general government debt of just over 40% of GDP looks positive compared to some other emerging markets such as Brazil or South Africa.


On the other hand, after the introduction of the currency-protected deposit product on 20 December 2021 and the subsequent implementation of the scheme, it is seen that the TRY volatility was included in certain bands. We think that the government will want to keep the exchange rate levels and volatility under control until the 2023 elections and can take additional measures if needed or demanded. As for the main monetary policy, we do not expect a tightening effect under current conditions.


The central bank; After the decline in 2019 and 2020, it decided to increase its reserves by expanding RR transactions and international swap agreements with local banks during the periods when the value of the country’s currency fell and no interest increase was desired. SDR + swap agreements (existing and new Korean agreement with China and Qatar) + rediscount credits will increase gross reserves, but the situation requiring caution regarding net reserves will remain. Although the gross reserves of the Central Bank increased by over 120 billion dollars with the said foreign reserve resources, it regressed with the interventions in the foreign exchange market in December and decreased to around 110 billion dollars at the beginning of January. Although we expect the gross reserves to continue to be reinforced with swap, RR and export rediscount credits, we do not expect the FX sales made from reserve deposits to be continuous. The decline in net reserves continues. Net reserves stood at $7.9 billion at the beginning of January, while net reserves excluding swaps stood at minus $56.9 billion.


Global Economic Outlook


Fed’s Tightening Phase


The Fed has entered the recycling phase of the ultra-loose policies it introduced in March 2020. After the Covid-19 crisis, the zero-interest and massive liquidity situation, which was implemented within the scope of the steps to revive the economy, now leaves its place to tightening policies after the global inflation crisis. In the gradual progress of the reflationary easing steps, the Fed reduced the pace of asset purchases in the first place and started to make the cuts in higher tranches with the decisions taken at the December 2021 meeting. In this context, the Fed is expected to completely end its bond purchases in March 2022.


The Fed has now abandoned the “temporary inflation” discourse and has made it clear that it intends to increase interest rates in response to a persistent/structural inflation concern. In this context, we think that the first step to increase interest rates at the March meeting will open the door to more than 3 interest rate hikes in 2022. In the baseline scenario we discussed, we estimate that the federal funding rate will be increased to 1.5% in 2023 and to 2% in 2024.


GDP growth continues after the pandemic and the labor market is recovering. In the projections put forward by the Fed at the December FOMC meeting, it is seen that the central tendency forecast range for 2022 is 3.6% – 4.5% in terms of growth. It is estimated that 2021 closed with 5.5%. On the unemployment rate side, the December realization of 3.9% is the best rate of the pandemic period and is below the FOMC projection range. The Fed estimates the unemployment rate for 2022 within the central tendency range of 3.4-3.7%. We think that even better than this rate can be achieved in light of the recovery in the labor market.


Although we expect a stagnation in CPI and PCE inflation in 2022 with the partial relief of global supply problems, we anticipate that the upward trend and high will continue. This will indicate the continuation of inflation above the Fed’s preference ranges. With the gradual easing of inflation pressures within the forecast horizon, we can expect a slow decline from the current 7% CPI inflation level. We expect the Fed’s preferred metric for PCE inflation and core PCE inflation to remain above the 2% target by the end of 2023. The Fed’s central tendency forecast range for 2022 is 2.2 – 3% for PCE inflation and 2.5 – 3% for core PCE inflation.


When we look at the frequency of the Fed’s decrease in bond purchases and increase in interest rates during the 2013 model tapering phase, it is seen that there is a one-year waiting period in between. The downsizing of the balance sheet started in 2017. We think that the gaps will not be as clear in the 2021 model tapering phenomenon. We predict that the Fed will not wait long for balance sheet reduction after taking the first interest rate step in March 2022. The normal phase of the balance sheet shrinkage will result from the Fed’s failure to repay the MBS and Treasury bonds that have been paid. We assess that the US bond market has not yet priced in details about the balance sheet reduction. We will see this strategy discussed and evaluated in more depth in the notes to the January 26 FOMC meeting.


The Fed will keep the end of the tightening open and follow a dynamic strategy so that inflation expectations do not get out of control. For this reason, we consider the lightest tapering dose to be the current level. If concerns over inflation rigidity and persistence increase, the Fed may tighten interest rates and accelerate further to bring the balance sheet down to 2015 levels. We expect such a phenomenon to push the US bond yields upwards. We see a theoretical range of 2-2.5% in 10-year bond yields as possible. This may bring along a broad-based dollar strengthening.


While all this was happening; The Fed will not want to cause another economic downturn that will lead to higher unemployment. Powell, who removed the phenomenon of “temporary inflation in inflation” from the Fed’s literature in November, underlined the changing views of policymakers and growing concerns about inflation. In addition, the Fed still does not want to remain cautious on the real interest rate side and harm the economic recovery. The Central Bank considers the course of the monetary policy appropriate in the current dynamics and deals with the inflation dynamics.


Inflation Concept and ECB Monetary Policy in the Euro Area


We can say that with the Eurozone inflation reaching 5%, a more challenging ground has emerged for the ECB. We will look at how valid is the perception that the worst is over in inflation, with the narrative of monetary policy shifting further towards tightening. The central bank’s updated forecasts forecast CPI inflation at 2.6% for 2021 and 3.2% for 2022, but they project inflation to decline to 1.8% for 2023 and 1.8% for 2024. From this point of view, we can say that the ECB forecasts remain more moderate, so we do not anticipate that broad-based tightening will be as aggressive as the Fed.


Of course, inflation is not the only factor influencing the gradual transition of the ECB. Increasing Covid-19 cases across the continent and downside risks on the growth curve of supply shortages will cause the liquidity composition to be kept cautious. While the ECB is ending purchases within the PEPP (Pandemic Emergency Purchase Program), it has temporarily supported purchases within the APP (Asset Purchase Program). The transformation of the policy will take place slowly and gradually, as the re-radiation of Covid cases involves the risk of economic activity. Within the scope of Pandemic Emergency Purchase, we expect bond purchases to be terminated at the planned stage, and to purchase more assets within the scope of APP for a few months against the dilemma of slowing economic growth and accelerating inflation.


Lagarde’s statements show that an urgent rate hike for 2022 is not currently being considered. To ensure a smooth exit from the expansionary policy, the ECB normalizes excess liquidity, ending purchases in the PEPP. In contrast, purchases within the APP will be widened for a short time and gradually reduced. We do not expect a regulation in ECB interest rates before 2023.


Rebalancing the Global Economy


Covid Variants, Supply Chains, Global Growth and Inflation Concerns, Policy Trend of Central Banks


After the Covid-19 outbreak first emerged in early 2020, the global economy has been hit by a significant shock. The aforementioned severe economic collapse then entered the recovery phase with the support provided by monetary and fiscal policies. The realization of economic openings with the introduction of vaccines and the easing of quarantine measures brought about a rapid recovery in growth.


We watched that new virus variants that emerged over time caused periodic concerns. In August, we are in the phase of watching a step forward version of the effects Delta could not create with Omicron. Of course, it poses some downside risks on the global economic rebalancing, but we think that the risks of slower growth at the moment are due to supply constraints that also feed inflation. As the aftershock of the Covid crisis, the global inflation crisis has come. We expect this situation to be challenging for the global economic growth in 2022.


Total demand is rising as economies open and the labor market rebounds. This, combined with tightened supply chains and logistical constraints, is causing serious global inflationary pressure. The problems arising from the source in the supply of raw materials and energy also cause a slowdown in the supply of goods. The price imbalances that arise when increasing demand and compressed supply are combined cause more inflation fluctuations in some countries.


In this context, we think that some G-10 central banks will deal with similar dynamics like the Fed and ECB we mentioned. The Bank of England (BOE) showed that it was preparing for inflationary conditions by making a modest interest rate increase in December. In turn, we expect the tightening to progress gradually against the increasing risks of Covid and global slowdown. Central banks such as Canada, Australia and New Zealand will follow the path of gradual tightening with similar dynamics. We expect the Bank of Japan (BoJ) to maintain its supportive monetary policy stance for a long time, at least until the end of 2022.


The Chinese economy is at risk of a sharp slowdown in 2022. The stakes are on the downside given the number and strength of the challenges, from Covid outbreaks to power cuts to real estate stress. Growth dynamics will be at the forefront of China’s policy shift, and we think easing inflation pressure will lead to further loan interest rate and RRR cuts to provide credit relief at the PBOC.


Developing Countries Economic Policy Response


Developing countries will adapt higher interest rates to their policies in 2022. This will, of course, aim to prevent or reduce the capital outflow due to the Fed’s future moves. The erosion effect of increasing US yields and the more gradual rate of increase in interest rates on local currencies may destabilize local currencies and feed inflation. We can expect import-intensive economies to be exposed to more vulnerability factors. The deterioration of price stability will be the most obvious obstacle to economic recovery. Therefore, it is an understandable policy objective to seek to manage the secondary effects of inflation with interest rates and tighter financial conditions. Therefore, we expect not many developing countries to have negative real interest rates.


In addition to Fed monetary policy, global economies may also experience less economic growth in 2022. Global supply chains slowdown, rising debt financing costs, local political and geopolitical developments, and the persistence of risks from Covid are all components of the downside risk balance on growth. Exporting countries may show more resilience due to the situations caused by commodity and energy prices. We see the proactive policy stance and the increase in crude oil prices, plus its strong strategic position as an energy provider, as an advantage for Russia. However, the geopolitical developments in Ukraine and Kazakhstan, the financial system and the US and EU sanctions that can be increased on the basis of companies should be considered as a disadvantage for the Russian ruble. We would also like to point out Brazil and South Africa as related to vulnerability factors due to their high political risk profiles. We expect real returns to come to the fore in an unstable political and economic environment.


While the general profile of developing countries is at the point of applying more stringent policies, we consider Turkey in an exceptional position outside of this equation. We think that looser monetary and fiscal policies will reduce the interest in the lira. While foreigners prefer higher-yielding alternatives in global capital movements, the tendency of locals to dollarize to store value continues to increase. We expect the lira’s low-yield position, which lacks policy support, to continue to weigh on the local currency. In terms of gaining confidence, we adopt the investor criteria specific to Turkey as a return to the policy perspective adopted by the market economy and the global financial system. The phenomenon of experimentalism in the economy may lead to increased instability.


Global Bond Yields


Although economic growth is a phenomenon to be followed, continued supply cuts and product scarcity are still effective on inflation acceleration. It is understood that the factor that will be subject to the Fed’s interest rate hikes earlier and more frequently than expected in 2022 is high inflation imbalances. The Fed’s tightening, interest rate and balance sheet moves will be the general theme of rising US yields.


Supply cuts and product shortages are likely to continue into 2022, keeping inflation high. In response to price increases, we would expect the Fed to adopt a more aggressive foothold in policies pursued by major central banks. The divergence in the economy’s growth profile and crisis potential will likely put the Fed ahead of other G-10s such as Europe, the UK and Japan. On the other hand; If inflation spirals out of control, risks could potentially lean towards higher interest rates and higher long-term bond yields for other major economies as well.


We expect the European Central Bank to reduce its overall bond purchases only very gradually and lag far behind the Fed in raising policy rates. We do not expect a rate hike in 2022 from the ECB, which will temporarily increase the pace of the ECB’s regular asset purchase program following the completion of the PEPP program.


While the 10-year yields in the US rise above March 2020, the negative yield bond stock in the world is decreasing. We will pay attention to the US-German spread, as there are signs of normalization and inflation in the Euro Area yields. Although inflation expectations have stabilized, we see that their high levels are still among the main expectations and concerns. The bond market expects the Fed to be more hawkish during the tightening process. We observe the movement in 10-year bond yields at 1.77% and the highest yield in 2 years. This move is important for the US-German spread. We think US yields will be priced to reflect inflation expectations and that the bond market is currently moving in that direction. We expect the trend towards the theoretical 2.50% band to accelerate, above the 1.70-75% critical range we have stated. A rate hike in March means a more serious tightening; This means that the Fed will both increase the possibility of more than three rate hikes and realize a rapid contraction of the balance sheet. The Fed can be expected to move faster for financial tightening.


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