Ishould be Bring respite. Instead, Turkey’s reappointment of Recep Tayyip Erdogan as president on May 28 surprised investors but deepened the country’s economic malaise. Over the past two weeks, the lira has lost 5% of its value against the dollar, falling to 21 to 1. Some economists think it could reach 30 by the end of the year, despite the government’s attempts to support it. The central bank’s net foreign exchange reserves are now depleted as savers and investors flee the currency.
These difficulties are symptoms of abnormal monetary policy. In 2021, facing inflationary pressures that led central banks around the world to raise interest rates, Turkey cut interest rates. Mr Erdogan believes that low interest rates will reduce inflation – contrary to economic orthodoxy – and he has repeatedly armed Turkey’s central bank with force to cut its policy rate. In fact, the overnight policy rate is currently at a low of 8.5%. According to official figures, the annual inflation rate reaches 86% in 2022 (see Figure 1).
Inflation has since moderated – reaching 44% according to official estimates, or higher according to independent estimates. Mr Erdogan’s lackeys boast that he has been right all along. In fact, inflation has fallen due to lower energy prices, central bank intervention in money markets, and “base effects,” where past price increases have raised the base from which inflation is calculated. Regardless, Mr Erdogan looks likely to continue his policies, at least for a while. In his victory speech, he insisted that as monetary policy eased, “inflation also comes down”.
However, Mr Erdogan is right in some respects. Turkey’s inflation is a mystery to economists, if not in the way he suggests. The persistence of low interest rates and high inflation suggests that real interest rates in Turkey have been extremely low for some time. This should quickly become unsustainable, as it enables speculators to make handsome profits by borrowing in lira and investing in stable assets such as housing or other currencies, further devaluing the lira and fueling inflation. So how did real interest rates stay negative for so long? What does this mean for the future path of inflation?
fishing for answers
First, one has to understand Mr. Erdogan’s approach. This was best articulated in 2018, when consultant Cemil Ertem provided an outline, referring to an equation that is incorporated into many economic models and named after the pioneering economist Iriving Fisher. The “Fisher equation” states that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation. Most economists agree that real interest rates are determined by factors such as long-term growth rates over which policymakers have little influence. Lower nominal interest rates should reduce inflation, at least according to Mr. Ertem’s explanation. Mr Ertem believes this could happen if companies pass on lower borrowing costs to consumers as lower prices.
However, when that theory was tested in late 2021, Mr Erdogan was proven wrong. After all, inflation continues to rise. The problem, says Selva Demiralp of University College Cork, is that the other channel through which interest rates affect inflation dominates the cost channel through which Mr Ertem expects inflation to be lower.
That still leaves a mystery behind Türkiye’s persistently deeply negative real interest rates. But it starts to unravel when other types of real interest rates are considered, which aren’t quite as negative yet. As Emre Peker of consultancy Eurasia Group puts it, “ [policy] Interest rates become irrelevant. ”
In some cases, interest rates are distorted by government policy. In the business sector, for example, banks are told not to lend above a certain rate. The result is that they just avoid making most loans. Credit is only available to favored industries such as construction. Turkey also requires banks to hold bonds against foreign exchange deposits, effectively subsidizing state borrowing.
However, in sectors where interest rate distortions are less severe, nominal and policy rates have moved inversely (see Chart 2). Inflation expectations have risen as investors do not believe the central bank will act to stem inflation in the future. This has led to higher interest rates on consumer loans, especially on long-term loans, as investors demand higher returns the less purchasing power they expect the lira to hold in the future. Therefore, judging by consumer loan rates, real interest rates may not be so negative.
Likewise, returns on other assets are well above central bank policy rates. This caused businesses, households and investors to flee the currency. The government wants to support the lira, but there is only so much it can do. When your reporter paid for a taxi in dollars in Istanbul at the market rate instead of the less generous black market rate—for a short time—he thanked your correspondent very much. Bekir, a shopkeeper at Istanbul’s Grand Bazaar, noted that vendors are taking it upon themselves to price their wares in dollars. Assets other than foreign currencies are also attracting investment, as all parties scramble to protect their savings. Ms. Demiralp noted, for example, that “there were long queues outside car dealerships”. House prices rose at three times the official rate of inflation. Some have speculated that foreign investors may attack the lira.
Governments try to prevent currency flight. Exporting companies must sell 40 percent of their foreign exchange earnings to the central bank. At the end of 2021, the government launched a plan to protect some lira deposits from devaluation. Almost a quarter of all deposits are now covered at a cost that is prohibitively high and not fully sustainable.
So, how to explain Fisher’s equation? Short-term policy rates have been low, but they have been much less relevant to borrowing because market rates have either risen on higher inflation expectations or credit has been rationed. Elsewhere, the result has been a plunge in the lira, prompting the use of soft capital controls. If Erdogan drives down market interest rates on the safe side, the result is likely to be hyperinflation.
Some economists believe Mr Erdogan’s victory and the face of a brewing currency crisis could soften his approach. Turkey’s economy will get some respite in summer, when energy consumption will drop and tourism revenue will rise. Mr Erdogan has been able to keep the lira stable thanks to one-off foreign exchange deals with friends including Russia and Saudi Arabia. In the fall, however, he may have to back away from his pledge to keep interest rates low, perhaps through indirect means such as easing caps on business lending rates. Warm weather and friendly favors won’t last forever. ■
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