Drivers of Turkish Inflation
One sentence summary: A conventional monetary policy increasing policy rates following an
increase in Turkish inflation or a depreciation of Turkish lira would
be optimal to achieve and maintain price stability in Turkey.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Quarterly Review of Economics and Finance.
Working paper version is available here.
Abstract
This paper investigates the drivers of Turkish inflation by using a structural vector autoregression model, where monthly data on global oil prices, unemployment rate, inflation rate, policy rate and exchange rate are used. The empirical results show that Turkish inflation increases following a negative policy rate shock, a positive exchange rate shock, or a positive global oil price shock. The volatility of Turkish inflation is mostly explained by global oil prices and exchange rate movements in the long run, while the contribution of exchange rate shocks to Turkish inflation has continuously increased over time. As additional empirical results show that exchange rate depreciation can be reduced by positive policy rate shocks, it is implied that a conventional monetary policy increasing policy rates following an increase in inflation or a depreciation of Turkish lira would be optimal to achieve and maintain price stability in Turkey, which is the primary objective of the Central Bank of the Republic of Turkey.
Non-technical Summary
Although inflation rates in many emerging markets have decreased over time due to having successful monetary policies, the current Turkish inflation deviates by having one of the highest rates among emerging markets (i.e., the second following Argentina). As Turkey has an inflation targeting regime with an independent central bank which states "The primary objective of the Bank is to achieve and maintain price stability." on its webpage, where price stability is highlighted, the drivers of Turkish inflation are important to understand to form optimal policy not only in Turkey but in also other emerging markets that have an inflation targeting regime.
Accordingly, this paper attempts to understand the drivers of Turkish inflation by using a structural vector autoregression (SVAR) model, where monthly data on global oil prices, unemployment rate, inflation rate, policy rate and exchange rate are used. The empirical investigation is based on monthly data covering the period between 2005:M1 and 2021:M8. The results based on impulse response functions suggest that policy rate pass-through into Turkish inflation is negative and significant, where 1% of a change in the policy rate results in about 0.7% of a reduction in inflation in the long run. The exchange rate-pass through into Turkish inflation is about 26%, whereas the oil price pass-through into Turkish inflation is about 14% in the long run.
The historical decomposition analysis further suggests that Turkish inflation has historically been driven by shocks of global oil prices and exchange rates, where the contribution of the latter has increased over time. Although policy rate shocks have also contributed to inflation historically, this contribution has been limited compared to those by shocks of exchange rates and global oil prices. The forecast error variance decomposition of Turkish inflation additionally suggests that about 40% of its variance is explained by global oil prices, whereas about 17% of its variance is explained by exchange rate movements.
To summarize, the empirical results suggest that Turkish inflation is mostly driven by shocks of global oil prices and exchange rates. The empirical results also show that the contribution of positive policy rate shocks to Turkish inflation is negative and significant, although the magnitude of the contribution is relatively less compared to those of global oil prices and exchange rates. As additional results show that exchange rate depreciation can be reduced by higher policy rates, it is implied that a conventional monetary policy increasing policy rates following an increase in inflation or a depreciation of Turkish currency (lira) would be optimal to achieve and maintain price stability in Turkey, which is the primary objective of CBRT.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Quarterly Review of Economics and Finance.