Inflation Targeting, Policy Rates and Exchange Rate Volatility: Evidence from Turkey

In January 2002, the Central Bank of Turkey (CBT) moved to an implicit inflation targeting framework, which included core attributes of an inflation targeting (IT) regime including, among other requirements, the announcement of a formal target for inflation. As a result of successful disinflation, prudent fiscal policy and implementation of reforms, Turkey introduced a full-fledged IT regime in 2006, which brought further transparency to the monetary policy framework. We found that during 2002-2006, among other factors, the developments in Turkey's risk premium played a very significant role in the path of policy rates. We arrived at this conclusion by estimating a Taylor rule describing the policy reaction function of the CBT. During this period exchange rate pass-through to inflation declined, and while capital inflows strengthened the real exchange rate, the nominal exchange rate and the financial markets in general were affected by occasional reversal of capital inflows. We offer a short discussion of CBT reaction to sudden stop episodes under the new monetary regime. Particularly, we ask whether the sharp increase in policy rates in response to the mid-2006 episode was a defense of the currency instead of adherence to an open economy IT regime. We also discuss whether softening of the targeted disinflation path may have been a viable option.