The release of the FOMC minutes stirred things up, as committee members showed they agreed that high inflation and tight labor market balance sheet reductions would begin soon. The minutes also emphasized that current economic indicators point to strong activity. This situation is confirmed by the current strong economic activity indicators of the US economy and allows the Fed to take a more comfortable position in advancing the tightening and to be proactive against inflation.
Minutes of the March FOMC meeting indicated that the committee will likely begin shrinking the balance sheet in May. The monthly upper limits for the Treasury and MBS runoff are likely to reach $60B and $35B, respectively, and to be phased in in just three months. This acceleration in the balance sheet coincides with a hawkish tone change in rate hikes. The accelerated timeline has helped flatten the yield curve.
Inflation is at the level of 7.9% as of February, and with the renewed energy prices equation in March, this rate is expected to increase much more rapidly. The inflation pressure, which forms the main lines of the Fed's stance, is also critical for the position of real interest rates. Because, although a rapid tightening path is foreseen for the Fed, the way forward for interest rates to catch up with inflation is far. The Fed needs about 4 years to reduce the balance sheet to pre-Covid at the current rate. It will likely accelerate as the asset portfolio is reduced. At the same time, due to the gap between inflation and the funding rate, rate hikes should have a disinflationary effect. The lower the Fed needs a terminal rate, the better the chance of not slowing the economy. If interest rate increases do not reduce inflation and if inflation, which is exposed to external influences, has secondary effects by distorting producer and consumer behavior, the risk of tightening to slow down the economy increases.
More central banks are expected to follow the Fed's lead in adopting a more aggressive policy stance. In this context, the stance of the European Central Bank will also be important in predicting the impact of potential interest rate hikes. Interest rates will not move in the same direction and we will see a US - Germany interest rate spread in line with a more proactive Fed against inflation and a more cautious ECB. The recent sanctions package imposed on Russia has increased the risk of recession for the Euro Zone, causing us to approach the issue of interest rate hikes with more skepticism.
Brent oil and US CPI comparison… Source: Bloomberg
Geopolitical Risks and Global Inflation Impacts
Inflation is likely to gain further momentum globally as a result of rising commodity prices. In this regard, the signals received from global economies are increasing and developing countries are also experiencing difficulties from the current situation. Although this situation is directly related to the continuation of the war conditions, we think that the transformation will not be so easy in an environment where economic relations are under the grip of sanctions.
Although reports suggest that the Russian army has indeed withdrawn from Kiev, Russian troops seem to be strengthening their positions in other parts of Ukraine to maintain stronger control. According to media reports, the attack on Bucha targeted Ukrainian civilians, not the military, which prompted President Biden and Western allied governments to declare new sanctions against Russia, and European governments to strongly consider stopping Russian energy imports. A meeting between Ukrainian President Zelensky and Russian President Putin was also raised as a possibility by both Ukrainian and Russian negotiators.
We will continue to receive mixed news feeds on the Russia and Ukraine conflict, and in the process, it looks like the West will continue to play the economic sanctions card, especially in defaulting on Russia. We will see the most striking results of this when energy and raw material imports from Russia are subject to a total ban. It is difficult to commission energy resources large enough to replace such an outcome, and it is likely that the global economy will be exposed to a serious supply deficit in this process. As Russia and Ukraine are major exporters of commodities and have a significant impact on commodity markets worldwide, interrupted supply and increased demand have the potential to push up oil and gas prices and food prices even further.
In order for inflation and supply chain problems to be normalized, the Russia-Ukraine problem, which created an additional current break, must first be eliminated. Firms are concerned about their ability to keep supply high in the midst of the ongoing conflict, which indicates that areas not normally within the magnitude zone may be exposed to indirect effects as well as the direct effects of the crisis.
Developing countries CDS comparison… Source: Bloomberg
Turkish Domestic Market Perspective
Recent geostrategic and economic developments have the potential to be reflected in Turkey's economic indicators and financial market movements, and point to a phenomenon that will particularly affect inflation and the current account deficit profile. Domestic producer inflation will be heavily affected by input prices in the world, and the PPI, which is currently 115%, may increase further. We have been talking about the spillover effect on the current CPI for a long time, and the general rise in commodity prices, especially Brent oil, will further this price spiral effect, as the current profile already points to a picture that comes after global prices. With the March data, CPI has reached the level of 61.1% and we expect it to maintain its high level on this path until the end of the year.
Comparison of Central Bank policy rate, TRY overnight swap rate and benchmark bond rate… Source: Bloomberg
We do not expect any action from the Central Bank for a while, and we foresee a policy expansion in line with the growth-oriented targets of the economy management for at least one more quarter. On the other hand, the channel to be provided with the current account balance in terms of foreign exchange stabilization has been somewhat blocked by factors such as recent energy price increases, potential tourism and export revenue reductions. If there is no normalization in energy prices, we expect the current account deficit to reach 51 billion dollars throughout the year. As for inflation, our assumption is that we will end the year at 53.1%. We have reservations about the impact of the liraization strategy, which includes price control mechanisms and TRY-based financial product incentives, that may provide continuity.
If the expectation of depreciation in TRY comes to the fore due to the Fed's rate hikes, the exchange rate effect may push inflation up again. There are many cost factors that affect inflation. We monitor many risk factors such as commodity prices, demand conditions, wages, managed prices, inflationary dynamics created by agricultural production in food. We expect the rise in inflation to continue until the summer months of the year and to decline slightly in the last month of the year due to the significant base effect after maintaining its high course for a while. At the beginning of 2023, the base effect in January, February and March of this year will help bring down the annual inflation rates.
While rising inflation and a significant decline in purchasing power reduce both predictability and confidence in the economy, the dollarization rate has been rising over the years. Financial dollarization, which was at the level of 55% at the beginning of 2021, entered the band of 60-65% and after the exchange-protected TRY deposit product, which guarantees possible losses from the exchange rate as of December 20, 2021, it has now fallen below the 60% band with the transformation of real and legal persons. By contrast, total bank deposits are still advancing at a historically high half dollarization rate. Considering that there is a 45-55% distribution between the Treasury / CBRT product, the total size of which was announced as 728 billion TRY as of April 11, we calculate the approximate budgetary burden as 10.3 billion TL at the current exchange rate. As we have always stated, the advancement of FX-linked product in terms of liraization depends on the ability of the system to feed itself. The fact that the exchange rate does not exceed the periodic interest yield keeps the difference manageable. However, if the financing need increases, we will have to take into account the fiscal deficit through the Treasury and the emission effect through the Central Bank. Since we did not receive any signal for price stability at the point of interest increase, the basic assumptions and analyzes will continue to be at the center of the FX-linked product.
The Effect of Monetary and Fiscal Policies and Financial Markets
In the new economy perspective, we see that the Central Bank focuses on economic management targets rather than inflation priority. At this point, fiscal policy has been given a greater role in reducing inflation to the level of developed countries in the medium term without using monetary policy. In this process, we see that the FX-protected deposit account will be at the center of mitigating the economic shocks caused by the exchange rates. However, as inflation rises or slows its decline, it will become more difficult to maintain this practice. There is a possibility that negative real interest rates will stimulate foreign exchange demand, low interest rates will heat inflation compared to general demand, and this will affect exchange rate movements and price expectations.
USDTRY, basket exchange rate and real effective exchange rate comparison Source: Bloomberg, CBRT
We would like to state that there has been no trend towards foreign portfolio inflows due to the significant deterioration in risk appetite recently. The high trend of borrowing costs may continue due to unconventional policies aimed at easing financial conditions. The increasing weight of Turkish assets in global indices originating from Russia is a potential opportunity and the funds released can create a positivity. 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.
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