Monetary Policy Modelling: New Directions

“Practice is ahead of theory, theory is ahead of

modelling ...” Erdem Başcı

Mehmet YörükoğluDeputy Governor

2013 Central Bank Macroeconomic Modelling WorkshopNovember 7-8 2013, Istanbul

2

Contents

I. The changing role of monetary policy in the pre

and post-crisis period

II. Changes in monetary policy modelling

approach

III. Turkish experience

3

The redesign of monetary policy strategy

How will monetary policy objectives and policy

tools evolve?

How will financial stability considerations be

integrated into the policy process?

What changes to the policy framework will be

adopted?

Challenging questions:

4

Pre-crisis consensus

Commitment to a strong nominal anchor

Inflation targeting

Main objective: price stability

Single instrument: interest rate

Subsidiary role for the financial system

5

Need for a new monetary policy framework

New role for central banks: avoid development

of financial imbalances

The post-crisis economic environment is

different

Unconventional policy instruments

Why a new policy framework?

6

Decoupling

The traditional monetary policy framework was

embraced by both emerging and developed

countries

The crisis created a decoupling

Problems and policy responses differed among

developed and emerging economies.

7

Crisis experience: Developed countries

sharp decline in growth,

deflationary pressures,

liquidity problems.

large-scale balance sheet policies,

provision of ample liquidity,

buying risky assets,

forward guidance...

Problems

Measures

8

Crisis experience: Emerging economies

volatile cross-border capital flows,

exchange rate appreciation,

rapid credit growth.

increasing bank reserve requirements,

restrictions on credit market,

taxing capital flows...

Problems

Measures

9

Capital flows

Improvement in Risk PerceptionsImprovement in Risk Perceptions Capital InflowsCapital Inflows

Balance sheet effects and easing

credit standards

Balance sheet effects and easing

credit standards

External Borrowing Currency appreciationEasier external finance

Capital flows affect economy significantly mainly through credit and exchange rate channels.

Financial Instability Cycle for an Emerging Market Economy

10

Turkish Experience

Financial Stability Concerns: Credit Growth

Source: CBRT.

Fast credit growth...

Total Loan Growth Rates (13 Weeks Moving Average, Annualized, FX Adjusted, Percent)

11

Main Sources of Current Account Deficit Finance*(12-months Cumulative, Billion USD)

*Short-term capital movements are sum of banking and real sectors' short term net credit and deposits in banks. Long-term capital movements are sum of banking and real sectors’ long term net credit and bonds issued by banks and the Treasury. Source: CBRT.

Financial Stability Concerns: Current Account

Current Account Balance(Seasonally Adjusted, Quarterly Average, Billion USD )

Source: TURKSTAT, CBRT.

Current account deficit widened significantly

Most of CA deficit was financed by short-term capital flows

12

Real Exchange Rates (ReR) in Turkey(2003=100, Logarithmic scale, Reverse order)

Financial Stability Concerns: Exchange Rates

EM countries are Brazil, Chile, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan and Thailand.Source: Bloomberg, CBRT.

Nominal currency appreciated around 20 percent, moving together with other EM currencies

Real exchange rates appreciated significantly compared to its long-term trend

TL and Other EM Currencies Against USD (9 March 2009=1)

13

Modification of inflation targeting regime

Adopting financial stability as a supplementary

objective.

Enriching the set of policy instruments:

wide assymmetric interest rate corridor,

reserve option mechanism.

14

Interest Rate Corridor

15

Reserve Option Mechanism

16

Reserve Option Coefficients Use of the ROM

Source: CBRT.

17

Results: Credit growth

Total Credit Growth (%)

Credit growth is contained.

Results: Current Account

18

Current Account Balance(12-month Cumulative, Billion USD )

Source: TURKSTAT, CBRT.

Main Sources of Current Account Deficit Finance*

(12-months Cumulative, Billion USD)

Source: TURKSTAT, CBRT.*Short-term capital movements are sum of banking and real sectors' short term net credit and deposits in banks. Long-term capital movements are sum of banking and real sectors’ long term net credit and bonds issued by banks and the Treasury.

Significant improvement both in the level and financing of the current account deficit.

19

Results: Exchange Rate

Correction of the initial overvaluation in the currency.

Low volatility of currency relative to peer emerging countries.

TL and Other EM Currencies Against USD (1 November 2010=1)

Implied FX Volatility (1-month)

Turkey

EM Currencies (with 20%-80% band

around the mean)

20

Overview

Practice is ahead of theory; theory is ahead of modelling ...

Incorporating financial stability along with the price stability, and a better management of global spill-overs

The crisis stimulated research on incorpotating the interactions between financial market imperfections and the real economy in policy models.

To understand the transmission of unconventional policies empirically, future research should continue to exploit the experience of central banks in the last five years.

Thank You.

Mehmet YörükoğluDeputy Governor

2013 Central Bank Macroeconomic Modelling WorkshopNovember 8, 2013, Istanbul