IMF Staff Papers

Vol. 51, No. 3

© 2004 International Monetary Fund

Would “Cold Turkey” Work in Turkey?

OYA CELASUN, R. GASTON GELOS, and ALESSANDRO PRATI*

When inflation rates in a country are persistently high, observers often believe that
the inflation process has become “inertial,” posing an obstacle to disinflation. Using
an innovative approach, we assess the empirical validity of this argument for the
case of Turkey. We find that the current degree of inflation persistence in Turkey is
lower than in Brazil and Uruguay prior to their successful stabilization programs.
More significantly, expectations of future inflation are more important than past
inflation in shaping the inflation process, providing little evidence of “backward-
looking” behavior. Using survey data, we find that inflation expectations, in turn,
largely depend on the evolution of fiscal variables. [JEL E31, E52]

B ringing down inflation from persistently high levels while avoiding economic
disruption remains one of the most important challenges for policymakers in
many developing countries. The critical question in a disinflation attempt is how
quickly inflation will respond to a tightening in monetary policy. If agents are pre-
dominantly 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

*Oya Celasun is an Economist in the Research Department, R. Gaston Gelos is an Economist in the
Western Hemisphere Department, and Alessandro Prati is a Deputy Division Chief in the Research
Department; all are with the International Monetary Fund. The authors wish to thank Richard Clarida,
Mark Griffiths, Juha Kähkönen, Ratna Sahay, Antonio Spilimbergo, Carlos Végh, an anonymous referee,
and the Editor for helpful comments and discussions, and the Research Department of the Central Bank of
Turkey for useful suggestions.
1 The literature on stabilization is too large to be discussed here. See Sargent (1982) for a study of the

process of ending hyperinflations and Calvo and Végh (1999) for an extensive discussion of inflation sta-
bilization in developing countries. Fischer, Sahay, and Végh (2002) provide an overview of modern hyper-
and high inflations, including disinflation episodes. Hamann and Prati (2002) study why many inflation
stabilizations succeed only temporarily.

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

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 ques-
tions 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 per-
sistently 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 prop-
erties 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 sta-
bilization programs. Second, using a framework similar to that in Galí and
Gertler (1999), and employing both price and survey data, we find that expec-
tations 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

2 See, among many others, the discussions in Chadha, Masson, and Meredith (1992), Celasun (2001),

Dotsey (2002), and Galí and Gertler (1999).

3 See the conference report of the 2001 conference of the National Bureau of Economic Research

(NBER) on Turkey under http://www.nber.org/crisis/turkey_report.html.

4 For an example of the use of survey data in the estimation of the Phillips curve, see Roberts (1995).

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 WOULD “COLD TURKEY” WORK IN TURKEY?

results from various alternative methods, hoping to assemble a body of convinc-

ing 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 back-
ground of low and declining inflation in most other countries, including many of

Figure 1. 12-Month CPI Inflation, Turkey, 1991–2003

(In percent)

140

120

100

80

60

40

20

0
Oct-91

Oct-94

Oct-97

Oct-00
Jul-92

Apr-93

Jul-95
Apr-96

Jul-98

Apr-99

Jul-01

Apr-02
Jan-91

Jan-94

Jan-97

Jan-00

Jan-03

Figure 2. GDP Growth, Turkey, 1991–2002

(In percent)

10
8
6
4
2
0
-2
-4
-6
-8
-10
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

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
Turkey entered the 1990s with a newly liberalized capital account, strong cap-
ital flows, and expansionary fiscal policies financed to a significant extent by mon-
etary 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 cri-
sis ensued. An IMF-supported program stemmed the crisis, but the program went
off-track in mid-1995. Nonetheless, capital flows to emerging markets were sub-
stantial 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 co-
ordinate 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 inter-
est bill due to the uncertainty associated with the path of inflation and incom-
plete 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 per-
cent at end-1997.
By the end of the decade, Turkey’s increasingly exceptional status among
emerging markets in experiencing high and volatile inflation led to heightened
perceptions of the cost of these high inflation rates. The resulting broadened con-
sensus on the desirability of disinflation and macroeconomic stabilization paved
the way for the disinflation efforts starting in 1998.
The government adopted a gradualist stabilization program in early 1998, tar-
geting an inflation rate of 50 percent by end-1998. The Russian financial crisis in
August 1998 led to severe capital outflows and a massive increase in public sec-
tor borrowing costs, but the monetary program was by and large maintained, and
inflation was brought down to about 70 percent at end-1998.
The year 1999 witnessed two severe earthquakes, a continued compression of
foreign capital, and a gross domestic product (GDP) decline of 4.7 percent. Against
a background of unwieldy borrowing conditions, the government adopted an
ambitious exchange rate–based disinflation program in December 1999, adopting
a crawling peg of the lira against a basket of 1 U.S. dollar and 0.77 euro, and tar-
geting a consumer price index (CPI) inflation rate of 25 percent by the end of

5 Unless otherwise noted, all data are from the Central Bank of Turkey.

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 WOULD “COLD TURKEY” WORK IN TURKEY?

Figure 3. Overall and Primary Deficit, Turkey, 1990–2002

(In percent)

20

Primary Deficit/GDP
15
Overall Deficit/GDP

10

-5

-10
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002
2002. A sizable fiscal retrenchment was achieved, but the exchange rate came
under severe pressure as a result of a liquidity shortage in the banking sector in
November 2000. The peg was broken in February 2001 following renewed pres-
sures in the banking sector and a massive outflow of foreign capital.
Despite a rebound of inflation following the devaluation and the switch to a
floating exchange rate regime in February 2001, inflation was on a declining path
in 2002–03, and the fiscal stabilization was sustained, underpinned to a sizable
extent by the long-postponed structural reforms.

II. What Do We Know About Wage and Price Indexation?

Although there is a perception that a significant share of wage and price contracts
in Turkey are indexed to past inflation, there is little comprehensive documenta-
tion of the nature of indexation in various sectors of the economy. The contract
length in the small fraction of the private sector covered by collective bargaining
(about 350,000 workers) is typically two years, with six-month backward indexa-
tion. The wages of the vast majority of workers are negotiated on a firm-by-firm
basis, and little is known about the contracts’ nature, except that their length is usu-
ally six months. The 2000 program agreed on with the IMF included a shift in the
inflation adjustment of civil service sector wages and pensions from a backward-
looking mechanism to a forward-looking adjustment in line with projected infla-
tion rates, with catch-up clauses. Currently, salaries of civil servants and blue-collar
workers in the public sector are adjusted twice a year. Little is documented about
other indexation mechanisms in the economy. Interestingly, Shiller (1997) cites
Turkey as a puzzling example of a country with high and variable inflation without
substantial indexing.
There is some inertia in public sector price adjustments, possibly contributing to
inflation persistence. The government budget uses a backward-looking revaluation

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

coefficient based on the average annual increase in the wholesale price index (WPI)
to determine many taxes and user fees. Prices of utilities, medical supplies, and many
food items are controlled by the government; the exact extent to which inflation
adjustments in these areas are characterized by systematic inertial (i.e., backward-
looking) behavior is not fully clear.
The time-series behavior of CPI subindices suggests that, in important non-
tradable sectors of the economy, prices tend to be adjusted with lags of several
month. We find that housing, health, and education prices appear to be the most
sluggish, while prices of food, clothing, and housewares are the most flexible.6 The
nontradable sector price increases seem to be set largely based on past inflation.
The left-hand panels in Figure 4 show, as we would expect in such a case, that the
ratio of the index of slowly adjusting prices (housing, health, education) to the
overall CPI increases as inflation declines from end-1997 to end-2000, and dimin-
ishes when inflation accelerates in 2001. The right-hand panels in Figure 4 show
that the ratios of those price categories that are more flexible than the average
move in the same direction as the inflation rate.

III. Persistence: A Univariate Analysis

How important is inflation persistence in the aggregate? A univariate analysis of
inflation dynamics indicates that inflation persistence in Turkey during 1994–2002
was small in both relative and absolute terms. We first estimated a simple regres-
sion of monthly CPI inflation on its lag and a linear trend for the period January
1994–February 2002. We then computed Andrews’s (1993) median unbiased esti-
mator of the first-order autoregressive parameter and obtained the half-life estimates
shown in Figure 5 by replicating this procedure on rolling samples of 60 observa-
tions.7 The estimated half-life of a unit shock to CPI inflation (the length of time
needed to halve the magnitude of the original shock) is only about one month and
has been relatively stable over time, remaining between 0.8 and 1.3 months over
the last three years (top panel of Figure 5).8
CPI inflation in Turkey is also less persistent than in Uruguay and Brazil prior
to their successful inflation stabilizations. Uruguay, like Turkey, had a history of
high but relatively stable inflation before embarking on a successful stabilization
program at the beginning of the 1990s, after inflation reached a peak of 140 per-
cent. The middle panel in Figure 5 shows that in Uruguay, the half-life of a unit
shock prior to stabilization was similar to or marginally higher than that of Turkey
in February 2002. The case of Brazil is also of interest because it was a country
with extensive backward wage and price indexation before the 1994 stabilization.

6 Food prices carry the largest weight in the CPI (31 percent), followed by housing (26 percent), cloth-

ing (9.8 percent), transportation (9.3 percent), housewares (9 percent), health (2.9 percent), entertainment
(2.9 percent), hotels and restaurants (2.8 percent), education (1.6 percent), and miscellaneous (4.5 percent.)
7 Stock (2002, p. 379–87), in a comment on Cogley and Sargent (2002), notes, “There are a variety of

ways to measure persistence, none perfect.” He then goes on to use a median-unbiased estimation method
similar to the one employed here.
8 We also repeated the analysis on quarterly data and obtained analogous results. For all these calcu-

lations, we modified a program that was originally written by Antonio Spilimbergo.

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 WOULD “COLD TURKEY” WORK IN TURKEY?

Figure 4. Inflation Inertia and the Components of the CPI Index

Inertial Components Flexible Components
1.3 1.10
Ratio of s.a. HOUSING prices Ratio of s.a. FOOD prices 1.05
1.2
to s.a. CPI (right axis) to s.a. CPI (right axis)
100 1.00
1.1
100 0.95
1.0 80
0.90
80
0.9
60 0.85
60
0.80
40 Year-on-year CPI inflation (left axis)
40 Year-on-year CPI inflation (left axis)

20 20
1995 1996 1997 1998 1999 2000 2001 1995 1996 1997 1998 1999 2000 2001

1.3 1.1
Ratio of s.a. HEALTH prices
Ratio of s.a. CLOTHING prices
to s.a. CPI (right axis) 1.2
100 to s.a. CPI (right axis)
1.0
1.1
80 0.9
100 1.0

80 0.9 60 0.8
60
40 0.7
40 Year-on-year CPI inflation (left axis)
Year-on-year CPI inflation (left axis)
20 20
1995 1996 1997 1998 1999 2000 2001 1995 1996 1997 1998 1999 2000 2001

1.6 1.00
Ratio of s.a. EDUCATION prices Ratio of s.a. HOUSEWARE prices
1.4 0.95
to s.a. CPI (right axis) to s.a. CPI (right axis)
100 0.90
1.2
0.85
100 1.0 80
0.80
80 0.8
60 0.75
60
0.70
40
40 Year-on-year CPI inflation (left axis) Year-on-year CPI inflation (left axis)

20 20
1995 1996 1997 1998 1999 2000 2001 1995 1996 1997 1998 1999 2000 2001

Note: The term “s.a.” stands for “seasonally adjusted.”

This is reflected in half-life estimates between four and seven months (bottom
panel in Figure 5).9
Although inflation persistence in Turkey is small, half-life estimates are
always significantly different from zero (top panel in Figure 5), suggesting that
further analysis is warranted. Univariate persistence may be due to backward-
9 The bottom panel of Figure 5 does not show the upper bound of the confidence interval for the half-

life of a shock to inflation in Brazil because the corresponding median unbiased estimator of the auto-
regressive parameter was 1, suggesting that the Brazilian CPI inflation series could be nonstationary, as
shown in other studies (see, for example, Durevall, 1999).

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

Figure 5. Inflation Persistence in Turkey,

Uruguay, and Brazil
(Median unbiased half-life estimates of a unit
shock and 90 percent confidence band)

3. 5
Turkey
3. 0

Half-life in MONTHS
2. 5

2. 0

1. 5

1. 0

0. 5

0. 0
1999 2000 2001
End of 5-year rolling sample

5
Uruguay
Half-life in MONTHS

0
1991 1992
End of 5-year rolling sample

8
Brazil
7
Half-life in MONTHS

1
1991 1992 1993
End of 5-year rolling sample

Note: The solid lines represent the median unbiased half-

life estimates of a unit shock, and the dotted lines represent the
limits of the 90 percent confidence bands. See footnote 9 on the
confidence bands of the estimates for Brazil.

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 WOULD “COLD TURKEY” WORK IN TURKEY?

looking price setting, but it is also consistent with forward-looking behavior. Serial
correlation in the variables that drive inflation, such as exchange rate deprecia-
tion or money growth, would reconcile univariate persistence and forward-looking
behavior. The next section assesses the relative importance of backward- and
forward-looking behavior by estimating a multivariate regression that nests both
hypotheses.

IV. The Relative Importance of Backward-

Versus Forward-Looking Behavior
The distinction between backward- and forward-looking price-setting behaviors is
important from a policy point of view because the output costs of a rapid disinflation
would tend to be higher with backward-looking behavior.10 By contrast, forward-
looking price setters would quickly take into account the implications for inflation
of a credible change in the monetary regime, thus making the costs of disinflation
relatively small. In this section, after describing the empirical model, we use two
alternative measures of inflation expectations—actual future inflation and survey
inflation forecasts—to assess the degree of forward-looking pricing behavior in
Turkey. We find that, although past inflation contributes to explaining current infla-
tion dynamics, expectations of future inflation play a much more important role.

Empirical Model
We estimate an empirical model that nests the possibility of both backward- and
forward-looking price-setting behavior. Traditional models of price stickiness with
purely forward-looking agents do not generate inflation persistence. The Calvo
(1983) model can be modified by assuming that only a fraction of the firms in the
economy are forward looking, while the rest are backward looking.11 As in the orig-
inal Calvo (1983) model, only a fraction of firms are assumed to change prices every
period, while the rest keep prices constant. Forward-looking firms have rational
expectations, and backward-looking price setters use a rule of thumb: they update
the average new price in the most recent round of price adjustments by the most
recently observed inflation rate. The resulting inflation rate in period t, πt equals

π t = (1 − δ )π t −1 + δEt π t +1 + λ( V t* − Pt ), (1)

where V t* corresponds to the logarithm of the price a forward-looking firm would

select for period t if it were able to reset its price in each period, and Pt is the loga-
rithm of the aggregate price level. The firms are assumed to be monopolistically
competitive and therefore choose V *t as the (logarithm) of a markup over nom-
inal marginal costs, in deviation from steady state. The term V *t − Pt then cor-
responds to the level of real marginal cost and is often proxied by the level of excess

10 See,
for example, the discussions in Ball (1994), Celasun (2001), or Buiter and Grafe (2001).
11 Similar
specifications have been used by Obstfeld (1995), Galí and Gertler (1999), Celasun (2001),
and Ghezzi (2001).

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

demand.12 We extend Celasun’s (2001) specification for the nontradables compo-

nent of the Turkish CPI to the overall CPI, and we include in the equation terms
proxying for marginal costs for tradable goods as well as the excess demand for
nontradable goods and services. The degree of inflation inertia is governed by the
parameter, 1-δ. The higher the share of backward-looking price setters, the larger
is the weight 1-δ on the lagged inflation term. Similar equations can be motivated
by other models that explain inflation persistence, such as Chadha, Masson, and
Meredith (1992), Fuhrer and Moore (1995), Jadresic (2000), and Holden and
Driscoll (2001).13

Estimates with Actual Future Inflation

We first estimate equations for Turkish CPI inflation, proxying expected future
inflation rates with actual future inflation rates. Given that the measurement error
introduced by using such a proxy is not orthogonal to the actual future realization
of the inflation rate, the appropriate estimation technique involves using instru-
mental variables that are orthogonal to the expectational error. Moreover, the error
term in this case follows an MA(1) process and is not necessarily homoscedastic,
so we use the generalized method of moments (GMM) to take into account the
structure of the error term. In addition to the lagged and future inflation terms, we
include terms proxying for the marginal costs and the excess demand of the trad-
able and nontradable components of the CPI, respectively—the real wage (rwage)
and the real exchange rate (rer)—and as a proxy for nontradables excess demand,
the relative price of tradables with respect to nontradables in the CPI index (trntr)
and the imports-to-GDP ratio (imp).14, 15 We do not impose any restrictions on the
coefficients of these terms, letting them be determined by the data.16 Our set of
instruments include three lags of inflation and all the other variables in the equa-
tion, three lags of the nominal interest rate, and a dummy variable for the second
quarter of 1994 to account for the effect of the April 1994 crisis. The constant term
in the equation is allowed to vary in the two subsamples, 1990: Q1–1994: Q1 and
1994: Q2–1998: Q1. The equation estimated for 1990: Q1–1998: Q1 is as follows,
with standard errors in parentheses:17
π t = 0.38π t −1 + 0.62 Et π t +1 + 0.44 rert
( 0.08 ** ) ( 0.11** )

+ 0.34 rwaget + 0.62 trntrt + 0.39 impt . (2)

( 0.09 ** ) ( 0.17 ** ) ( 0.05 ** )

12 Galí and Gertler (1999) argue that proxies for marginal costs should be used instead of an excess

demand/output gap variable. See also the discussion in Celasun (2001). We will use both approaches below.
13 Chadha, Masson, and Meredith (1992) show that when δ is greater than 0.5, there is a money growth

rate that keeps the output gap at zero along the disinflation path.
14 See Celasun (2001) on the motivation for the measure used to proxy nontradables excess demand.
15 All variables are in logarithms, and except for the real wage, in deviation from a linear trend. For

the logarithm of the real wage, the quadratic trend was also statistically significant and therefore was used
along with the linear one in detrending.
16 The presence of the real exchange rate term accounts for the possibility that a share of firms, most

likely in the tradables sector, “index” their prices to the current and expected future domestic level of for-
eign prices (i.e., the exchange rate multiplied by foreign prices). We plan to test in future work whether
some price setters index to the exchange rate in a backward-looking manner.
17 **Denotes significance at the 1 percent level.

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 WOULD “COLD TURKEY” WORK IN TURKEY?

Figure 6. Turkey: Backward-Looking Behavior in CPI

(Recursive GMM estimates of lagged inflation coefficient
and 95 percent confidence band)

0.6
ERBS

lagged inflation coefficient

0.5 stabilization

0.4

0.3

0.2

0.1

0.0

- 0.1
1998 1999 2000 2001
End of sample beginning in 1990:1

Note: The shaded area covers the period of exchange rate based
stabilization (ERBS).

The weight on expected future inflation is significant and positive but below
one, and not statistically distinct from 0.5. All the four driving variables also enter
the equation in a statistically significant manner, with the expected sign. Hansen’s
J-statistic has a p-value of 0.378, implying that the instruments and the model are
valid. To examine whether the degree of inflation inertia changed over time as a
result of the recent disinflation efforts, we extend the sample by adding recur-
sively one quarter of observations at a time, through 2001: Q4.
Figure 6 presents the estimates of the backward-looking coefficient 1-δ for
CPI inflation obtained by gradually extending the sample period.18 The estimates
show some evidence of inflation inertia, but the weight on lagged inflation falls
from about 40 percent in the 1990: Q1–1998: Q1 sample to less than 15 percent
in the full sample, suggesting that price setters’ behavior has become increasingly
forward looking. Possibly, this is the result of the disinflation strategy followed in
recent years, in particular the switch to forward-looking wage setting in the pub-
lic sector mentioned above.19

Estimates with Survey Inflation Forecasts

We obtain broadly similar results when estimating equations in which survey
CPI inflation expectations from Consensus Forecasts are used in lieu of expected
18 The estimated coefficient on the relative price of tradables with respect to nontradables (trntr) is sta-
tistically indistinguishable from zero in samples that end after 1999: Q3, but all other variables in the equa-
tion remain statistically significant in driving inflation.
19 The results are broadly in line with findings by Diboog – lu (2001) based on the GDP deflator.

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 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

inflation.20 Survey data allow us to depart from the rational expectations assumption
made above and bypass the need to use the GMM. For Turkey, Consensus’s fore-
casts for average inflation in the current year and the following year are available on
a monthly basis for the period 1995:1–1998:05 and bimonthly since then. In addi-
tion, since 1998:05, Consensus has been providing expectations data for the six indi-
vidual months ahead, on a bimonthly basis. We estimate regressions for seasonally
adjusted monthly and bimonthly inflation for 1998:05–2002:02 and semiannual and
annual inflation for 1995:01–2002:02.21 For the inflation regressions for monthly or
bimonthly inflation, Consensus data exist only for two years at a bimonthly fre-
quency, reducing the number of observations. For those regressions that assume
either six-month or one-year contracts, we have more than seven years of data at a
monthly frequency.22 As a measure of excess demand, we use a seasonally adjusted
series of capacity utilization, which is available on a monthly basis.
In most specifications, the estimates using survey forecast data reinforce the
notion that inflation persistence does not have its main origin in backward looking
behavior (Table 1). In the regressions with forecast horizons of six months and one
year, the coefficient on lagged inflation is statistically indistinguishable from zero.
In the estimates with a forecast horizon of one and two months, the evidence is
more mixed. However, these regressions have small sample size and low explana-
tory power relative to those with six-monthly and annual inflation, casting doubt
on the reliability of the estimates.23
Granger-causality tests provide another indication that price setters are forward
looking. Granger-causality tests are essentially tests of temporal precedence. If price
setters were mainly backward looking, then changes in inflation would Granger-cause
changes in inflation expectations, and not vice versa. However, the pattern is the
opposite: for all horizons, we cannot reject the hypothesis that inflation expectations
Granger-cause actual inflation, but the hypothesis that actual inflation Granger-causes
inflation expectations can be rejected at the usual confidence levels (not shown).

V. What Determines Inflation Expectations?

As inflation expectations appear to play a dominant role in the price-setting mech-
anism, we conduct an empirical investigation of their determinants. We run two
types of regressions to explain consensus forecasts of average inflation over the

20 We used the mean forecast of 15 different economic forecasters, including 13 Turkish and foreign

private financial institutions, Istanbul Bilgi University, and the Turkish Industrialists’ and Businessmen’s
Association.
21 The specification remains constant across the estimations. The equation for, say, n-monthly inflation

includes n-months lagged (n-monthly) inflation, expected n-month ahead inflation, and the n-month aver-
age of capacity utilization, as well as a constant term. We restrict the sum of the coefficients of lagged and
expected future inflation to one, as in the GMM regressions.
22 Six-month and one-year average inflation expectations are computed using a weighted average of

this year’s and next year’s expected inflation rate. In the case of six-month inflation, we assume that
expected inflation was equal for the whole 12-month horizon. Given that these data are available only at a
bimonthly frequency since May 1998, we interpolate data for the missing months.
23 The recursive estimates of the coefficient of lagged inflation (not shown) are quite stable since mid-

1997.

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 WOULD “COLD TURKEY” WORK IN TURKEY?

Table 1. CPI Inflation Regressions with Survey Data

(Newey-West standard errors in parentheses)
Forecast One One Two Two Six Six One One
Horizon Month Month Months Months Months Months Year Year

Lagged 0.529* 0.655* 0.527* 0.868* 0.016 −0.240 −0.128 −0.243

inflation (0.069) (0.129) (0.184) (0.184) (0.166) (0.148) (0.010) (0.136)
Inflation 0.471* 0.345* 0.473* 0.132 0.984* 1.240* 1.128* 1.243*
forecast (0.069) (0.129) (0.184) (0.184) (0.166) (0.148) (0.099) (0.136)
Capacity 0.176* 0.172* 0.003 −0.067 −0.106 0.130 0.057 0.661
utilization (0.046) (0.046) (0.145) (0.174) (0.305) (0.296) (0.679) (0.831)
(seasonally
adjusted)
Constant −13.55* −12.831* −0.246 4.962 12.257 −5.144 10.445 −36.961
(3.330) (3.332) (10.759) (13.23) (23.073) (22.25) (53.24) (61.725)
Estimation bimonthly bimonthly bimonthly bimonthly monthly monthly monthly monthly
frequency
Instrumental no yes no yes no yes no yes
variables
Estimation 5:1998– 5:1998– 5:1998– 5:1998– 1:1995– 1:1995– 1:1995– 1:1995–
period 2:2002 2:2002 2:2002 2:2002 2:2002 2:2002 2:2002 2:2002
Number of 23 23 23 23 86 75 86 51
observations
R2 0.31 0.24 0.00 0.00 0.55 0.58 0.60 0.70
Notes: *Denotes significance at the 5 percent confidence level. The set of instrumental variables
include the constant term, inflation forecast, and the current value and three lags of the capacity uti-
lization rate.

following 12 months. In the first set of regressions (first two columns of Table 2),
we try to explain inflation expectations with a set of standard variables: monetary
growth, the difference between the overnight rate and the deposit rate (to measure
the stance of monetary policy), capacity utilization (to proxy for excess demand),
lagged inflation, and exchange rate changes.24, 25 In addition, to assess whether
inflation expectations are driven by expectations of monetization of fiscal deficits,
we include the primary balance and the change in the nominal debt stock (both as
24 We did not address the separate question of whether inflation expectations are rational. A quick exam-

ination suggests that survey forecasts are unbiased, but not efficient. The fact that lagged inflation helps
explain expectations is not inconsistent with the earlier results, in which expectations of future inflation drive
current inflation. It suggests that a reduced-form equation could express current inflation as a function of
lagged inflation, an excess demand/marginal cost term, and other variables explaining expectation formation.
25 We subtract the slow-moving deposit rate from the overnight rate to control for the fact that the same

level of policy rates can reflect a different stance of monetary policy, depending on the general level of nom-
inal interest rates. Including the exchange rate as an explanatory variable is problematic, because, at least in
periods in which it is floating, the exchange rate is a jump variable that captures inflation expectations. The
qualitative results presented below are not affected by the exclusion of the exchange rate variable.

505
506

Table 2. Determinants of CPI Inflation Expectations

(Dependent variable: mean Consensus forecast of average inflation over the following 12-months;
Newey-West standard errors in parentheses)

Oya Celasun, R. Gaston Gelos, and Alessandro Prati

Specification I Specification II Specification III Specification IV

Inflation (lagged) 0.486* (0.095) 0.790* (0.196) 0.982* (0.112) 1.223* (0.260)
Capacity utilization (lagged, seasonally adjusted) 0.917* (0.212) 0.452 (0.515) −1.133 (0.637) −0.841 (0.880)
Expected consolidated fiscal balance (as percent of GNP) — — −2.687* (0.693) −4.484* (1.617)
Change in debt stock (in percent of GDP, seasonally adjusted,
year-on-year, lagged one month) 0.022* (0.006) 0.030* (0.006) — —
Primary balance (as percent of GDP, seasonally adjusted,
lagged one month) −0.104* (0.025) −0.085* (0.022) — —
Overnight rate minus deposit rate (lagged) 0.005 (0.012) 0.017 (0.011) — —
Year-on-year M1 growth (lagged) −0.003 (0.061) −0.019 (0.093) — —
Year-on-year exchange rate change (lagged) 0.629* (0.165) 0.758* (0.171) — —
Constant −44.127* (17.575) 33.990 (31.455) 49.213 (50.895) −5.775 (78.752)
Instrumental variables for lagged inflation? No Yes No Yes
R2 0.79 0.69 0.80 0.71
Number of observations 82 82 23 23
Estimation frequency monthly monthly bimonthly bimonthly
Breusch-Godfrey serial correlation test (p-value) 0.00 0.00 0.00 0.01
Note: *Denotes significance at the 5 percent confidence level.
 WOULD “COLD TURKEY” WORK IN TURKEY?

ratios to GDP) as fiscal variables. In the second set of regressions (last two
columns in Table 2), we relate inflation expectations to expectations about the size
of the fiscal deficit. As data on fiscal expectations are available only since May
1998 at a bimonthly frequency, the number of observations in this case is much
smaller. Moreover, given that fiscal balance expectations might be endogenous (at
a minimum because inflation expectations affect interest rates and, thus, expected
fiscal balances), we also estimate this specification with instrumental variables.26
There is evidence that fiscal variables play an important role in determining
inflation expectations. The results suggest that market participants closely follow
fiscal developments when forming inflation expectations. In particular, in the first
two columns of Table 2, the primary balance and changes in the debt (lagged one
month) do have the expected sign (higher debt and deficits are associated with
higher inflation expectations) and are significant at the 5 percent level, even after
controlling for a broad set of variables.27, 28 The two fiscal variables alone explain
43 percent of the variation in inflation expectations (not shown).
These results are confirmed by the second set of regressions (last two columns
in Table 2), where the expectation about fiscal deficits significantly enters the
regression, even when instrumented. Moreover, expected fiscal deficits remain
significant in regressions explaining survey expectations even when we include
expected M2 growth and expected GDP growth over the next 12 months as
explanatory variables (not shown). The latter finding suggests that fiscal deficits
affect inflation expectations, and not only because higher fiscal deficits increase
expected money growth over a 12-month horizon. In addition, they increase the
probability of monetization over a longer horizon, thereby augmenting, with a suf-
ficiently forward-looking money demand, expected inflation also in the short run.

VI. Conclusion
Backward-looking behavior does not seem to pose a major obstacle to reducing
inflation in Turkey. Instead, credible fiscal consolidation appears to be crucial for
lasting disinflation. Inflation expectations are likely to decline only if the public
perceives that the temptation to monetize fiscal deficits or inflate away the debt
stock has come to an end. The fact that the improvements in the noninterest fiscal
balance in 2000–01 have coincided with a marked drop in inflation expectations
lends support to this view, although the lack of demand pressures following the
February 2001 crisis is also likely to have contributed to the disinflation and the
downward adjustment of inflation expectations. Concurrently, the authorities
could consider policies aimed at eliminating residual forms of backward indexa-
tion in wages and prices (such as housing rents and health and education prices),

26 We use past changes in the debt stock as instruments for the forecast of the fiscal balance.
27 Several studies have analyzed econometrically the relationship between public sector deficits and
inflation in Turkey (see, for example, Metin, 1998). See also Lim and Papi (1997) and Alper and Ucer
(1998).
28 One might wonder whether the lagged inflation term is the regressor that explains most of the vari-

ation in inflation expectations. This does not seem to be the case. For example, in specification I, the R2
excluding lagged inflation is 0.55.

507
 Oya Celasun, R. Gaston Gelos, and Alessandro Prati

which are likely to account for the remaining role of past inflation found in the
econometric analysis.
The approach developed here has a broader applicability beyond the specific
Turkish case. In particular, we believe that the use of survey data to assess the
importance of backward-looking behavior in shaping the inflation process and
the examination of the determinants of these expectations are useful tools to
inform policymakers who face the task of reducing inflation from persistently
high levels.

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