1

Central Bank of TurkeyDepartment of Research and Monetary Policy

INFLATION EXPECTATIONS IN TURKEY:HOW SERIOUSLY SHOULD

WE TAKE THEM?

A. Hakan KaraPrepared for the ICE-TEA Conference 11-13/09/2006

2

Expectations Matters

It is a “response” variable Observable measure of credibility

Question: Where do you expect inflation to be two years from now?CB’s favorite answer: The TARGET

Main policy transmission channel Implications for price setting

behavior, output-inflation tradeoff

3

Quantitative inflation expectations series in Turkey

Survey of Expectations CPI inflation

Business Survey PPI inflation

Manufacturing Industry Survey Manufacturing price inflation

CNBC-e and Reuters

4

Survey of Expectations

Current Month’s CPI inflation Two months ahead One year ahead End-year Recently, two years ahead and one

month ahead expectations

5

Monthly inflation and expectations

-1

0

1

2

3

4

5

6

7

Aug

-01

Nov

-01

Feb-

02

May

-02

Aug

-02

Nov

-02

Feb-

03

May

-03

Aug

-03

Nov

-03

Feb-

04

May

-04

Aug

-04

Nov

-04

Feb-

05

May

-05

Aug

-05

Nov

-05

Feb-

06

May

-06

InflationExpectation for current monthExpectation for 2-months ahead

6

End-year Inflation Expectations

MIN, MAX and the TARGETMIN, MAX and the TARGET

0

10

20

30

40

50

60

70

Jan-2002 Jan-2003 Jan-2004 Jan-2005 Jan-2006

Target

Max.

Min.

7

Inflation outturns were below one-year ahead expectations throughout 2002-2005

0

10

20

30

40

50

60

Aug

-02

Nov

-02

Feb

-03

May

-03

Aug

-03

Nov

-03

Feb

-04

May

-04

Aug

-04

Nov

-04

Feb

-05

May

-05

Aug

-05

Nov

-05

Feb

-06

May

-06

Expected Inf.

Inflation

8

Testing the Performance of Inflation Expectations

Unbiasedness Do agent’s systematically overestimate

and/or underestimate inflation? Efficiency

Do agents use the available information to forecast inflation?•Learning from past mistakes•Using other relevant information

9

Test of Unbiasedness

ft

ftft 10

0: 00 H 11 and

10

Results of Unbiasedness Tests

Dependent Variable

Expectation Sample Sample Size 0 1 2 MA

Monthly CPI Inflation Current-month 2001:08-2006:07 60 -0.13 1.02 0.68 0 (0.144) (0.072) (0.51)

Monthly CPI Inflation 2-months ahead 2001:10-2006:07 58 -0.05 0.92 1.55 2 (0.205) (0.148) (0.46)

Annual CPI Inflation 12-months ahead 2002:08-2006:07 48 1.63 0.65 118.5 12 (1.551) (0.043) (0.00)

11

Recursive Learning Behavior

Rolling Coefficients Rolling Coefficients ffor Unbiasednessor Unbiasedness (current month) (current month)

((HHoo:: α0==0 and α1 =1)=1)

-0.60

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

Jul-0

4

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Jan-

06

Mar

-06

May

-06

Jul-0

6 0.96

0.98

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

1.16

α0

α1 (secondary axis)

12

Rolling Coefficients for UnbiasednessRolling Coefficients for Unbiasedness ( (12-months ahead12-months ahead))

((((HHoo:: α0==0 and α1 =1)=1)

One year ahead expectations are biased

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

Jul-0

5

Aug

-05

Sep

-05

Oct

-05

Nov

-05

Dec

-05

Jan-

06

Feb

-06

Mar

-06

Apr

-06

May

-06

Jun-

06

Jul-0

6

0.60

0.62

0.64

0.66

0.68

0.70

0.72

0.74

α1 (secondary axis)

α0

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Tests for Efficiency

ftt

ftft X 10

0: 101 H

Should hold in the equation:

The hypothesis

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Results of Weak Efficiency Test

Weak Efficiency Tests for CPI Inflation Expectations(CBT Survey of Expectations)

Kaynak: IMF IFS

Dependent Variable

Expectation Sample Sample Size 0 1 2 2 MA

Monthly CPI Inflation Current-month 2001:10-2006:07 58 -0.14 0.07 -0.10 1.22 0 (0.09) (0.12) (0.12) (0.31)

Monthly CPI Inflation Next 2-months 2002:01-2006:07 55 -0.21 0.01 - 2.42 2 (0.13) (0.14) - (0.30)

Annual CPI Inflation Next 12-months 2003:09-2006:07 35 -2.14 0.27 - 15.45 12 (3.68) (0.23) - (0.00)

15

Strong Efficiency Test

1 1 2 Cons 3.09

(0.33) 0.86

(0.81) 2.45

(0.51) cpit 1 -0.05

(0.65) -0.14 (0.27)

-0.20 (0.15)

wpit 1 0.03

(0.70) -0.04 (0.61)

0.03 (0.73)

E xchange ratet-1 0.03 (0.21)

0.08 (0.01)

-

Onct-1 -0.01 (0.35)

-0.003 (0.77)

-0.004 (0.75)

Cut-2 -0.04 (0.32)

-0.01 (0.84)

-0.03 (0.52)

Salest-2 0.02 (0.13)

-0.002 (0.89)

0.01 (0.69)

Dddt-2 0.07 (0.11)

0.03 (0.60)

0.02 (0.72)

F-stat 1.47 (0.19)

34.71 (0.00)

9.81 (0.20)

Sample 01:08- 06:07 01:10-06:07 01:10-06:07 Sample size 60 58 58 MA 0 2 2

Current month 2-months ahead

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How well the exchange rate explain the forecast errors?

Moving Moving Window EstimatesWindow Estimates

Kaynak: TÜİK, TCMB.

-0.040

-0.020

0.000

0.020

0.040

0.060

0.080

0.100

Sep

-04

Oct

-04

Nov

-04

Dec

-04

Jan-

05

Feb

-05

Mar

-05

Apr

-05

May

-05

Jun-

05

Jul-0

5

Aug

-05

Sep

-05

Oct

-05

Nov

-05

Dec

-05

Jan-

06

Feb

-06

Mar

-06

Apr

-06

May

-06

Jun-

06

Jul-0

6

17

Conclusion-1

Performance of the short term expectations have improved over time

The degree of unbiasedness and efficiency have increased gradually

However, the longer term forecasts are biased and inefficient

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Conclusion-2

Private agents’ expectations should not serve as the main “response variable” for the monetary authority

The essence of building structural models

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Conclusion-3

Agents largely focus on the short term inflation outlook

Temporary or one-off shocks to inflation may lead to undesired volatility in the financial markets

Maintaining a medium term strategy remains to be a challenge

CB should lead the markets Necessitates intensive effort in

communication

20

Central Bank of TurkeyDepartment of Research and Monetary Policy

INFLATION EXPECTATIONS: HOW SERIOUSLY SHOULD WE

TAKE THEM?

A. Hakan Kara

Prepared for the ICE-TEA Conference 11-13/09/2006

21

Targets and expectations for 12-month ahead inflation versus realizations

0

10

20

30

40

50

60

70

%

12 Months Ahead Expected Inflation

Annual Inflation

Targeted Path

Target path

Expected Inf.

22

How do agents form expectations?

Kaynak: TCMB.

Simple OLS Results

12 Months Ahead Expected Inflation = * Past Annual CPI + (1-)* Targeted Path Sample: 2001:09-2005:12

12 Months Ahead Expected Inflation Sum of Coefficients

Restricted to 1

Unrestricted

Coefficients

Targeted Path (1-) 0.66 0.65

Past Annual CPI 0.34 0.38

23

Expectations and fitted values

Kaynak: TÜİK, TCMB.

0

10

20

30

40

50

09.01

01.02

05.02

09.02

01.03

05.03

09.03

01.04

05.04

09.04

01.05

05.05

09.05

%12 Months Ahead ExpectedInflation

Fitted

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Standart Deviation/Mean

0,00

0,05

0,10

0,15

0,20

0,25

0,30

0,35

2001 2002 2003 2004 2005 2006

25

Target and Realization

05

10152025303540

2002 2003 2004 2005

End-Year Inflation Target End-Year Inflation Realization