How should a central bank react to currency collapse and high inflation? The classic means are higher interest rates. But in Turkey the central bankers prefer to do the opposite.
The markets are like gravity. Even if you ignore it, the effect does not go away. This is impressively evident in Turkey. Although inflation is rising sharply and the currency is depreciating even more sharply, the central bank is lowering interest rates. The result: the lira crash and the threat of hyper-inflation.
The lira has lost around half of its value against the dollar and the euro since the beginning of the year. The decline had picked up speed in November, with the currency losing around a quarter of its value. Inflation is officially more than 20 percent. The question arises: Why does the central bank allow this?
The reason has a name: Recep Tayyip Erdogan. The Turkish president has made the formally independent central bank subject – and he wants the lowest possible interest rates at all costs.
He gets that too. Erdogan has fired three central bank governors over monetary policy differences. In the spring he had fired central bank chief Naci Agbal and replaced him with Sahap Kavcioglu – a declared friend of low interest rates. Since September the central bank has reduced the key interest rate from 19 to 14 percent. There is little doubt that things will continue to decline.
Re-election in view
Erdogan’s calculation is risky. He wants to stimulate the economy with low interest rates and a weak lira. Turkish products are cheaper on the world market and holidays in Turkey are cheaper for foreign tourists. In addition, it is becoming more attractive to take out loans – with 20 percent inflation and 15 percent interest, the real interest rate is negative.
In fact, the Turkish economy grew 7.4 percent in the third quarter. The International Monetary Fund assumes that the gross domestic product will increase by 9 percent this year – that would be one of the strongest rates in the world.
Erdogan absolutely needs growth. Presidential elections are due in Turkey in a year and a half at the latest, and the incumbent head of state wants to be re-elected. His popularity is falling, and right now, polls don’t look good for him.
Erdogan hopes the high inflation will recede soon and the current consequences are only temporary collateral damage. Many economists point out that this can go wrong: an ever depreciating lira and high inflation rates could affect the entire economy.
Turks can afford less and less because of inflation and currency depreciation. Vital imports such as energy and raw materials are becoming even more expensive. In addition, Turkey is becoming less attractive for investors due to high inflation. Because you have to allow for a quick devaluation of your money. A vicious circle: inflation contributes to the fact that money flows into currency areas with more stable currencies and higher interest rates. This will ensure that the lira will come under further pressure and boost inflation.
“Mother of all evil”
Until the presidential elections, the self-proclaimed “interest enemy” Erdogan is unlikely to change course. It fits in with the fact that he describes interest rates as the “mother of all evil” and, contrary to economic doctrine, claims that high interest rates lead to high inflation and low interest rates lead to low inflation.
A different logic is used in economics. Accordingly, higher interest rates tend to dampen prices because they make loans more expensive. In addition, saving is more worthwhile. That means: companies invest less, consumers consume less. This reduces the demand for products and makes it more difficult to push through price increases. But that also slows economic growth. But that’s exactly what Erdogan doesn’t want.
Consequently, the president blames dark powers for inflation and the collapse of the lira. He complains about an ominous “interest lobby”, anti-Turkish foreign exchange speculators and opportunistic rating agencies. He perceives contradictions as an insult to majesty. The central bank follows this.