1. 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. 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. 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. 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. 5 Monthly inflation and expectations

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

7. 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. 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. 9 Test of Unbiasedness and

10. 10 Results of Unbiasedness Tests

11. 11 Recursive Learning Behavior Rolling Coefficients for Unbiasedness (current month) (H o : = =1) (H o : α 0 = 0 and α 1 =1) -0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 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-06 0.96 0.98 1.00 1.02 1.04 1.06 1.08 1.10 1.12 1.14 1.16 α0α0 α 1 (secondary axis)

12. 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 -0.50 0.00 0.50 1.00 1.50 2.00 Jul-05 Aug-05Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 0.60 0.62 0.64 0.66 0.68 0.70 0.72 0.74 α 1 (secondary axis) α0α0

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

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

15. 15 Strong Efficiency Test 1 1 2 Cons 3.09 (0.33) 0.86 (0.81) 2.45 (0.51) cpi t1   -0.05 (0.65) -0.14 (0.27) -0.20 (0.15) wpi t1   0.03 (0.70) -0.04 (0.61) 0.03 (0.73) Exchange rate t-1 0.03 (0.21) 0.08 (0.01) - Onc t-1 -0.01 (0.35) -0.003 (0.77) -0.004 (0.75) Cu t-2 -0.04 (0.32) -0.01 (0.84) -0.03 (0.52) Sales t-2 0.02 (0.13) -0.002 (0.89) 0.01 (0.69) Ddd t-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 MA 0 2 2 Current month2-months ahead

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

17. 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. 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. 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. 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. 21 Targets and expectations for 12-month ahead inflation versus realizations Target path Expected Inf.

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

23. 23 Expectations and fitted values Kaynak: TÜİK, TCMB.

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