...monetary policy. agents predominantly forward looking and the monetary tightening is credible, actual and expected inflation will quickly adjust to the new regime and the output costs will be small, even if disinflation is rapid--that is, if a "cold turkey" policy is adopted. (1) By contrast, if agents' price-setting behavior is backward looking because of wage and price indexation or adaptive expectations, disinflation will need to be more gradual to minimize output losses. For this reason, it is important to be able to assess the extent to which inflation has an "inertial" component. Methodological questions on how to address this problem have therefore received significant attention in the academic literature. (2)

Turkey is an ideal case study for these issues, because it has experienced persistently high inflation since the 1970s. In contrast to many other high-inflation countries, which at some point experienced hyperinflation. Turkey's inflation has never exploded, with annual inflation rates hovering around stable but gradually increasing plateaus, ranging from 40 percent to 120 percent over the last decade. This persistence has led many to believe that inflation is largely driven by inertia, with entrenched inflation expectations posing an obstacle to any disinflation attempt. In fact, the failure of the 2000 stabilization program supported by the International Monetary Fund (IMF) has been attributed by many to the presence of inflation inertia. (3)

We find little empirical support for this argument. First, the univariate properties of inflation dynamics show that the current degree of inflation persistence in Turkey is lower than that of Brazil and Uruguay prior to their successful stabilization programs. Second, using a framework similar to that in Gali and Gertler (1999), and employing both price and survey data, we find that expectations of future inflation are more important than past inflation in shaping the inflation process. Third, an examination of the determinants of inflation expectations shows that expectations depend largely on the evolution of fiscal variables.

Contrary to a widely held view, these findings suggest that backward-looking contracts do not pose a serious constraint to the disinflation process. Indeed, authorities could effectively control the speed of the disinflation by adopting and maintaining policies that influence expectations of future inflation. Moreover, since inflation is determined to a large extent by forward-looking behavior, output costs associated with a rapid disinflation program are likely to be relatively low. A credible fiscal consolidation is probably the key to reducing inflation, because inflation expectations will decline only if the public perceives that the need to monetize fiscal deficits or inflate away the debt stock has come to an end.

On methodological grounds, our paper innovates by making extensive use of survey data. While survey data have previously been used in the literature, we go one step further by attempting to explain the formation of expectations, explicitly distinguishing between fiscal and monetary factors. (4)

The main aim of this paper, however, is to answer a policy question; for this reason, we do not restrict ourselves to a single empirical approach, but present the results from various alternative methods, hoping to assemble a body of convincing evidence supporting our conclusion.

I. Macroeconomic Setting in 1990-2003

High inflation and volatile economic growth have been defining features of the Turkish economy over the last few decades (Figures 1 and 2). Against a background of low and declining inflation in most other countries, including many of the formerly chronic-inflation cases of Latin America, Turkish inflation averaged 80 percent per year in 1991-99. While a number of stabilization attempts were made throughout the decade, for most of the 1990s disinflation was not on the forefront of the policy agenda. (5)

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

Turkey entered the 1990s with a newly liberalized capital account, strong capital flows, and expansionary fiscal policies financed to a significant extent by monetary expansion. When the government attempted to increase the share of direct monetary financing to curb interest payments in early 1994, the loss of confidence in the lira and the reversal of capital inflows were swift, and a major currency crisis ensued. An IMF-supported program stemmed the crisis, but the program went off-track in mid-1995. Nonetheless, capital flows to emerging markets were substantial in 1995-97, and the Turkish economy enjoyed strong economic growth on the back of short-term capital inflows.

Although the aftermath of the 1994 crisis was characterized by incomplete structural reform efforts and the absence of a credible nominal anchor to coordinate inflation expectations, progress was made in some areas. The balance on the primary fiscal account averaged a surplus of 2.2 percent in 1994-97, as opposed to a deficit of 0.8 percent in 1990-93 (Figure 3). Central Bank financing of the fiscal deficits was gradually reduced and eliminated from 1997 onward. Nonetheless, the improvement in the primary balance was partly reversed after 1996, and the overall deficit of the public sector--the primary deficit plus interest payments--remained high. This reflected also the high interest bill due to the uncertainty associated with the path of inflation and incomplete confidence in the fiscal policy adjustments. Monetary policy remained accommodating, subordinating any quest of inflation reduction to the goal of stabilizing the financial markets toward a smooth functioning of the government domestic borrowing process. Inflation, as a result, ratcheted up to around 100 percent at end-1997.

By the end of the decade, Turkey's increasingly exceptional status among emerging markets...

NOTE: All illustrations and photos have been removed from this article.



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