2.1 Price Stability and Monetary Policy - TCMB 2023 Annual Report (2024)

2.1.1 Overview

Economic activity, which remained robust in the first half of 2023 on the back of domestic demand, lost momentum on a quarterly basis in the third quarter but rebounded in the last quarter. On the production side, the services sector stood out as the main driver of growth in 2023. The negative contribution of industrial sector value added to annual growth in the first half of the year, which was attributable to earthquake-related effects and weak external demand, turned positive in the second half of the year. Thus, the growth composition on the production side displayed a more balanced picture between industry and services in the second half of the year. On the expenditures side, although the contribution of final domestic demand remained high on an annual basis, it declined due to the slowdown in private consumption growth, and the negative contribution of net exports to annual growth waned in the second half of 2023. Meanwhile, investments made a strong contribution to annual growth, led by machinery-equipment investments.

The current account balance posted a deficit of USD 45.4 billion in 2023. Although the energy balance made the largest negative contribution to the current account deficit on an annual basis, this negative impact diminished due to the year-on-year decline in energy prices. The foreign trade balance excluding gold and energy made a negative contribution to the current account balance, driven by strong domestic demand, while the positive contribution of services items to the current account balance continued to rise. Regarding the financing of the current account balance, direct investments continued to be mainly driven by non-residents’ real estate purchases. On the portfolio investment channel, while there were outflows from equity and government domestic debt securities (GDDS) markets in the first half of the year, capital inflows were recorded in these markets as of June. Meanwhile, capital inflows in 2023 were mainly driven by the increase in non-residents’ deposits. In annualized terms, the banking sector’s long-term debt rollover ratio exceeded 100% in the last two months of 2023 and stood at 114% in December. This ratio was close to 100% for non-bank financial corporations. Thus, an improvement was observed in external financing facilities.

In 2023, robust economic activity was also reflected in the labor market, leading to a sustained downtrend in the unemployment rate. In 2023, the unemployment rate dropped by 1.0 percentage point year-on-year to 9.4%. Thus, total employment in 2023 increased by around 880 thousand people compared to the previous year and reached 31.6 million.

Annual consumer price inflation receded in the first half of 2023 on the back of the decline in international commodity prices and the stable course of the Turkish lira, but rose markedly in the third quarter due to the exchange rate, wage revisions, tax adjustments, and energy price hikes. In the last quarter of the year, the underlying trend of inflation improved thanks to the impacts of the policy steps taken, and consumer inflation ended the year at 64.8%. While the trend of core indicators B and C displayed a significant slowdown in the last quarter of the year, their annual inflation stood at 68% and 70.6%, respectively. While exchange rate developments and wage revisions were the main drivers of the rise in inflation throughout the year, tax adjustments were another factor affecting the inflation outlook. Despite decelerating in the second half of the year, aggregate demand conditions remained inflationary throughout the year, while the decline in import prices in US dollar terms had a favorable impact on inflation developments. In administered prices, subsidies for households in electricity and natural gas items had a favorable impact on the inflation outlook, while tax measures and administered price adjustments announced in the second half of the year pushed inflation up. Inflation expectations started to improve as of September with monetary tightening. Producer inflation, on the other hand, declined significantly in the first months of the year driven by the favorable outlook in international commodity prices and the base effect, but rose in the rest of the year due to cost-side effects, particularly exchange rate developments, and ended the year at 44.2%.

In the first half of 2023, the CBRT kept its policy rate unchanged except for a 50 basis-point cut in February. Starting in June, the CBRT embarked on a monetary tightening cycle to control the deterioration in pricing behavior as part of its disinflation strategy. Accordingly, in seven Monetary Policy Committee meetings between June and December, the policy rate was raised by a total of 34 percentage points, from 8.5% to 42.5%. The monetary tightening since June was also supported by the simplification of the micro- and macroprudential frameworks to enhance the functionality of market mechanisms and strengthen macro financial stability. The simplification policy was implemented gradually to ensure a smooth transition, and selective credit and quantitative tightening steps were taken to support the monetary tightening process. In addition to policy rate decisions, the CBRT also took quantitative tightening steps by extending the sterilization tools at its disposal to support the monetary tightening process.

2.1.2 Developments in 2023

Monetary Policy Developments

The Monetary Policy Committee kept the policy rate unchanged at 9% at its first meeting in 2023. After the earthquake disaster, the MPC cut the policy rate by 50 basis points to 8.5% at the February 2023 meeting. The policy rate remained at this level until June. This period saw macroprudential policies playing an increasingly important role in maintaining financial stability.

The buoyant domestic demand in the first half of the year had a negative impact on the current account balance and financing conditions. This process, accompanied by the decline in international reserves, increased volatility in financial markets and signaled a significant deterioration in pricing behavior. In June, the CBRT stated that the underlying trend of inflation had increased and concluded that the current monetary and financial conditions were far from bringing inflation to the 5% target in the medium term. Against this background, the CBRT assessed that the monetary policy strategy needed to be revised and initiated a monetary tightening process in June. The CBRT emphasized the importance of price stability for macroeconomic and financial stability and decided to implement a monetary tightening process that would be strengthened as much as needed in a timely and gradual manner. Accordingly, the CBRT raised the policy rate from 8.5% to 15% in June and 17.5% in July, communicating that the monetary tightening process would continue until a significant improvement in the inflation outlook was achieved. Moreover, selective credit and quantitative tightening measures were taken at the July meeting to support the monetary tightening process.

Noting that the underlying trend of inflation continued to rise in August, the CBRT concluded that additional pressure on inflation above the projected level emerged through the expectations channel. The CBRT communicated publicly in a timely manner that inflation would rise in the short term and hover close to the upper bound of the forecast range presented in the July Inflation Report at the end of the year. The CBRT drew attention to the higher-than-expected deterioration in inflation expectations and pricing behavior, and continued monetary tightening to anchor inflation expectations and keep the deterioration in the pricing behavior under control so that disinflation could be established in 2024. To this end, the CBRT delivered strong monetary tightening in August, raising the policy rate from 17.5% to 25%.

The policy rate was raised from 25% to 40% in the September-November period due to the higher-than-expected inflation in the third quarter, the stickiness of services prices, and the deterioration in inflation expectations, which continued to exert upward pressure on inflation. In November, the CBRT publicly shared its assessment that the level of monetary tightness required for the establishment of disinflation had been approached to a significant extent and communicated that the pace of monetary tightening would be eased and the tightening steps would be completed in a short period of time. Loan rates were assessed to be in line with the targeted level of financial tightness in December, as in November. Along with the 250-basis point increase in the policy rate decision taken in December, the CBRT stated that the regulations to increase the share of Turkish lira deposits, accompanied by monetary tightening, would continue to strengthen the transmission mechanism and improve the funding composition of the banking system. On the other hand, the CBRT underlined that it would continue to implement quantitative tightening by extending the sterilization tools at its disposal in order to support the monetary tightening process.

The strong monetary tightening process initiated in June as part of the fight against inflation was also supported by policy measures that safeguard macro financial stability. The CBRT simplifies the existing micro- and macroprudential framework in line with impact analyses in a way that will enhance the functionality of market mechanisms and strengthen macro financial stability. The effects of the steps taken as part of simplification are observed through the strengthening of the functionality of market mechanisms and the monetary transmission mechanism. This process strengthens monetary transmission as well as financial stability as the share of Turkish lira deposits in the financial system increases while the share of FX-protected and FX-denominated deposits declines. The ability of the banking system to fulfill its intermediation function with utmost efficiency is a prerequisite for achieving the disinflation process. In this context, practices that disrupt financial intermediation and adversely affect financial stability by distorting credit distribution are being removed within a predictable framework. The normalization of the commercial loan flow, the increase in the share of export and investment loans, and the slowdown in retail loan growth are taking place concurrently through the simplification measures and policy instruments put in place.

Inflation Developments

Annual consumer inflation lost pace in the first half of 2023 amid the decline in international commodity prices, with energy in the lead, coupled with the steady course of the Turkish lira. Then, the third quarter was marked by the rise in the exchange rate, wages and energy prices as well as tax adjustments. The simultaneous occurrence of multiple all-time-high shocks accelerated the passthrough from shocks to prices and led to a dramatic rise in inflation in this quarter. Monthly inflation rates lost momentum in the last quarter of the year and along with the improvement in the underlying trend of inflation, annual consumer price inflation ended the year at 64.8 %, quite close to the mid-point of the forecast shared in the October Inflation Report (Chart 2.1.2.1). Seasonally adjusted monthly inflation in core indicators B and C decelerated significantly in the last quarter, recording annual inflation rates of 68% and 70.6%, respectively, at the end of the year.

In 2023, the course of inflation was shaped by cost-side effects, mainly exchange rate developments and wage adjustments, while tax adjustments stood as another factor to affect the inflation outlook. Aggregate demand conditions lost momentum in the second half of the year, yet remained inflationary across the year. On the other hand, the decline in USD-based import prices had a favorable effect on inflation developments. Regarding administered prices, the reduction in household electricity tariffs and the natural gas subsidy offered to households improved the inflation outlook, while tax measures and administered price adjustments announced in the second half of the year pushed inflation upwards. Having increased across the year, inflation expectations improved as of September backed by the developments in monetary policy (Chart 2.1.2.2). Producer inflation receded notably in the first months of the year owing to the positive outlook in international commodity prices and the base effect, but pressures led by producer prices followed a strong course due to cost developments chiefly led by exchange rate developments in the remainder of the year.

Annual inflation in the food and non-alcoholic beverages group stood above the headline inflation at the end of 2023 with 72.0%. It is considered significant that food prices rose due exchange rate developments, minimum wage hikes, cyclical price adjustments and tax hikes, which escalated input costs. Across subcategories, the main driver of food inflation was the unprocessed food group, which surged by 91.2% year-on-year. Having soared by 138.5% year-on-year due to supply-side problems, red meat prices became the main driver of unprocessed food inflation. Annual processed food inflation followed a relatively more favorable course and ended the year at 58.1%. However, across subcategories, prices of processed delicatessen meat products recorded a high increase due to soaring meat prices. In the second half of the year, the rise in bread and cereals prices accelerated due to the termination of the flour regulation of the Turkish Grain Board (TMO) in June as well as wage hikes. Against this background, food and non-alcoholic beverages made the second highest contribution to annual inflation after services.

Energy prices tumbled amid falling international energy commodity prices as well as the reduction in electricity tariffs for households and the free use of natural gas in May. Having recorded the highest increase among subcategories in 2022 with 94.4%, energy prices rose by 27.2% in 2023, well below the headline inflation. Brent crude oil prices per barrel, which surged in 2022 amid the Russia-Ukraine war, followed a volatile course in 2023, but declined by an average of nearly 20% compared to the previous year. However, exchange rate developments accompanied by tax adjustments caused domestic fuel prices to rise. Fuel prices soared by 73.9%, which became the second highest price increase in the energy sub-group after liquid hydrocarbons. As natural gas was provided free of charge to households for one month in May and 25 cubic meters of natural gas was provided for free for one year, the impactpulled natural gas prices significantly downwards, resulting in an annual inflation of -18.3% in the natural gas group. On the other hand, the sizeable build-up of European gas stocks and the increased production from alternative energy sources drew down international natural gas prices, supporting this outlook. Meanwhile, domestic electricity prices receded notably due to the discount in April and the flat course in other months. Increases in municipal water prices stemming from the backward-indexation behavior hindered a more positive outlook in energy. All in all, the contribution of the energy group to annual inflation remained at 3.9 points as of end-2023.

In 2023, services inflation became the largest contributor to consumer inflation with 24 points. High annual inflation rates were registered across subcategories, and increases in other services and restaurants-hotels inflation led by exchange rate and wage developments as well as the backward indexation mechanism stood out. Price changes in the other services subcategory were driven by maintenance-repair items, which are highly sensitive to exchange rates, and education and health services, which are subject to cyclical pricing, while the uptick in inflation in the restaurants-hotels group was led by food prices and minimum wage adjustments. Rent inflation surged throughout the year due to the backward-indexation behavior in contracts and rising house prices as well as supply-demand mismatches in the real estate market. The outlook for transport services was influenced by seasonal revisions in administered services and fuel price developments. As a result, being impacted by wage developments due to its labor-intensive structure and recording a backward-indexation behavior, the services sector completed the year at 90.7% and became the main driver of the rise in inflation in 2023.

Core goods prices soared by 52.8% in 2023. The core goods inflation outlook was shaped both by cost-side effects, with exchange rate developments in the lead, and by the implications of the course of domestic demand. With a high and rapid exchange rate passthrough, the durable goods group posted an upsurge in inflation in the third quarter of the year, led by the automobile item, while white goods and furniture items also registered hikes. Likewise, pharmaceuticals and hygiene products were the main drivers of inflation in the other core goods group, driven by exchange rate developments. As cost passthrough was largely completed in the third quarter and as the shocks waned, monthly core goods inflation and its underlying trend decelerated in the last quarter of the year. Among the components of core goods, clothing and footwear saw an annual inflation of 39.7% at the end of 2023.

Supply-Demand Developments, External Balance and Labor Market

In 2023, economic activity was robust and gross domestic product (GDP) increased by 4.5% on an annual basis. In the first quarter of the year, GDP rose by 4% year-on-year, while it edged down by 0.2% quarter-on-quarter (Chart 2.1.2.3). In the second quarter, economic activity remained strong, and GDP increased by 3.9% annually and by 3.6% compared to the previous quarter. On the production side, the services sector remained as the main driver of annual and quarterly growth in the second quarter underpinned by strong tourism activity. On the other hand, industrial value added restrained growth in this period due to weak external demand. On the expenditures side, backed by the robust course of private consumption, domestic demand became the main driver of growth, while net exports had a dampening effect on quarterly growth (Chart 2.1.2.4). In the third quarter of the year, GDP grew by 6.1% annually, while quarter-on-quarter growth slowed down and GDP posted a limited increase of 0.3 percent compared to the previous quarter. In the last quarter of the year, GDP growth was 4% on an annual basis and 1% on a quarterly basis. In the second half of the year, the composition of growth calculated by both in terms of expenditure and production signaled for a rebalancing. On the production side, industrial value added started to contribute positively to annual growth, and the strong outlook in the services sector was maintained. On the expenditures side, tighter financial conditions led the contribution of private consumption to annual growth to diminish, while that of investments increased driven by machinery-equipment investments. Meanwhile, the negative contribution of net exports to annual growth posted a decline in the second half of the year.

In the first half of 2023, despite the strong outlook in services balances and the decline in energy imports, the annualized current account deficit hit the highest level of the year with USD 60.1 billion in May due to the brisk course of domestic demand coupled with substantial gold imports (Chart 2.1.2.5). After a flat course in the first quarter of the year despite the impacts of the earthquake, exports recorded an increase in the second quarter. On the other hand, imports, especially consumption and gold imports, remained strong due to the robust domestic demand, despite falling energy imports amid the downtrend in energy prices. In the first half of the year, the marked growth in gold imports had an upward effect on the current account deficit whereas the rise in services revenues bolstered by the sizeable contribution of tourism and transport sectors supported the current account balance. The ongoing weak course in economic activity in Türkiye’s main export partners led by the policies pursued by the major central banks continued to restrain external demand in the third quarter, and exports declined. On the other hand, in the second half of the year, the decelerating effects of the monetary tightening on financial conditions and the rebalancing in domestic demand on imports became visible. In this period, in addition to the slowdown in gold imports, the seasonally adjusted growth in imports of consumption and investment goods lost momentum on a quarterly basis. In 2023, the energy balance was the largest negative annual contributor of the current account deficit, which widened to USD 45.4 billion (Chart 2.1.2.6). On the other hand, the negative impact of the energy balance on the current account balance waned in tandem with the falling energy prices compared to the previous year. The foreign trade balance excluding gold and energy contributed negatively to the current account balance, while the positive contribution of services items continued to increase. On the financing front, direct investments continued predominantly through property purchases of non-residents. Portfolio investments saw capital outflows in stocks and GDDS markets, whereas these markets recorded capital inflows since June, which accelerated in the last quarter. On the other hand, capital inflows were mostly bolstered by the increased non-residents’ deposits in 2023. Debt rollover ratios of the banking sector increased in the second half of the year, and for long-term loans hovered around 113.5% in 12-month cumulative terms as of December.

The strong course of economic activity in 2023 was also mirrored in the labor market, and the downtrend in the unemployment rate continued (Chart 2.1.2.7). In the first quarter of the year, employment increased quarterly in all non-farm sectors. In this period, the labor force participation rate declined slightly, and the unemployment rate stood at 9.9% (Chart 2.1.2.8). In the second quarter, industrial employment remained almost flat, while employment in the services and construction sectors rose further. In this period, the labor force participation rate remained unchanged, while rise in employment pulled the unemployment rate down. In the third quarter of the year, despite the loss of momentum in economic activity, the labor market exhibited a more resilient outlook. In this period, employment rose on the back of services and construction as in the second quarter, while industrial sector employment remained sluggish. On the other hand, the labor force participation rate posted a quarterly decline and contributed to the downtrend in the unemployment rate. In the final quarter of 2023, the seasonally adjusted unemployment rate decreased by 0.4 points quarter-on-quarter to 8.8%. Meanwhile, the labor force participation rate remained flat at 53.2% in the same period. Thus, in 2023 total employment rose by about 900 thousand people compared to previous year, while the unemployment rate fell by 1.0 percentage point to 9.4%.