The impact of financial stability on monetary policy in Turkey

Since the early 1990's short term interest rate has been implemented as a main policy instrument, as inflation targeting strategy within the main objective of price stability framework, has been adopted by central banks. However, the inadequacy of policy interest rate in explanation of the changes in financial markets especially in the last twenty years, led the monetary policymakers to develop more comprehensive and stable instruments. Liberalization of capital accounts has increased the impatcs of global financial crisis on the real economy; and therefore the objectives of the central banks have göne through various changes. In addition to price stability, achiviement of financial stability has also been included among the main objectives of the central banks. In line with these developments, in 1990 New Zealand and Canada Central Banks have computed monetary condition index (MCI) as a weighted sum of short term interest rates and exchange rate variables, in order to monitor developments in the money market, and started to use it as one of the instrumental variable. However, because of the recent improvements in the financial markets, MCI has become insufficient in the prediction of the impacts of monetary policy on economic activity. Because of these drawbacks, the variables that MCI includes have been extended to other variables such as short and long term interest rates, risk premium, asset prices, stock and housing prices, and the new indices have been defined as financial conditions index (FCI). An increase in the calculated index indicates financial easining, and a decrease usually indicates financial tightening which results with financial crisis. The main aim of this paper is to construct financial conditions index for Turkey to be used in monetary policy analysis and to investigate the functioning of monetary transmission mechanisms using this index. In this context, the paper is composed of two parts. The first part of this paper aims to calculate alternative FCIs and evaluate the forecasting performance of them for Turkey covering the period 1992:1 and 2015:12. For this purpose, first financial conditions indexes are constructed based on four methodologies: Reduced form demand functions, VAR generalized impulse response functions, dynamic factor model and factor-augmented VAR (FAVAR). The performance of the alternative FCIs are assessed in terms their in-sample and out-of-sample forecasting ability to industrial production. and the best performing indices is determined. In the second part of the paper, time-varying parameter (TVP-VAR) models are estimated where the best FCI's selected in the first part is employed as one of dependent variables. By these estimates, the effectiveness of monetary transmission mechanism -interest rate, exchange rate, share price, credit and expectations channel- under different financial conditions are evaluated for Turkey. In this respect, this paper aims to combine two related topics such as FCI and monetary transmission mechanism. In this regard, it is expected that analysis results will provide valuable information to monetary policymakers about the functioning of monetary transmission mechanisms.