The Deterioration in Credibility, Destabilization of Exchange Rate and the Rise in Exchange Rate Pass-Through in Turkey

Abstract

The early literature on inflation targeting (IT) regime argues that adopting an IT regime in itself reduces the exchange rate pass-through (ERPT). The basic logic behind this argument is that pursuing a credible and independent monetary policy will help to anchor the inflation expecta-tions and stabilize the exchange rate volatility. In this study, we investigate whether the ERPT has increased in the last decade in Turkey where the credibility of the Central Bank of the Republic of Turkey (CBRT) has deteriorated and the exchange rate uncertainty has increased due to the weakening of commitment to inflation after political pressures although the IT regime has been implementing. Employing the Phillips curve model and then applying a narrowing window analysis, we have found that the ERPT coefficient increased as the beginning of the sample ap-proaches towards the last observation, especially since 2011. To search for the reason behind this increase, we additionally employed a threshold regression method following the work of Murase (2013) which allows both possibility of non-linearity in the ERPT relationship and exogenously adding the threshold variable to the model. When the gap between inflation expectations and the inflation forecasts grows, then the credibility is considered to decrease and we found that the ERPT gets higher if the gap exceeds a certain threshold. Similarly, we have found evidence supporting that the ERPT coefficient was higher when the exchange rate uncertainty exceeded a certain threshold.