1 Central Bank of Turkey Department of Research and Monetary Policy INFLATION EXPECTATIONS IN TURKEY: HOW SERIOUSLY SHOULD WE TAKE THEM? A. Hakan Kara Prepared 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

6 End-year Inflation Expectations MIN, MAX and the TARGET

7 Inflation outturns were below one-year ahead expectations throughout 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 and

10 Results of Unbiasedness Tests

11 Recursive Learning Behavior Rolling Coefficients for Unbiasedness (current month) (H o : = =1) (H o : α 0 = 0 and α 1 =1) Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul α0α0 α 1 (secondary axis)

12 Rolling Coefficients for Unbiasedness (12-months ahead) ( (H o : = =1) ( (H o : α 0 = 0 and α 1 =1) One year ahead expectations are biased Jul-05 Aug-05Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul α 1 (secondary axis) α0α0

13 Tests for Efficiency Should hold in the equation: The hypothesis

14 Results of Weak Efficiency Test Weak Efficiency Tests for CPI Inflation Expectations (CBT Survey of Expectations) Kaynak: IMF IFS

15 Strong Efficiency Test Cons 3.09 (0.33) 0.86 (0.81) 2.45 (0.51) cpi t1   (0.65) (0.27) (0.15) wpi t1   0.03 (0.70) (0.61) 0.03 (0.73) Exchange rate t (0.21) 0.08 (0.01) - Onc t (0.35) (0.77) (0.75) Cu t (0.32) (0.84) (0.52) Sales t (0.13) (0.89) 0.01 (0.69) Ddd t (0.11) 0.03 (0.60) 0.02 (0.72) F-stat 1.47 (0.19) (0.00) 9.81 (0.20) Sample 01:08- 06:07 01:10-06:07 01:10-06:07 Sample size MA Current month2-months ahead

16 How well the exchange rate explain the forecast errors? Moving Window Estimates Kaynak: TÜİK, TCMB.

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

18 Conclusion-2 Private agents’ expectations should not serve as the main “response variable” for the monetary authority The essence of building structural models

19 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 Turkey Department 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 Target path Expected Inf.

22 How do agents form expectations? Kaynak: TCMB. Simple OLS Results

23 Expectations and fitted values Kaynak: TÜİK, TCMB.

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