Selva Demiralp

Selva Demiralp is a professor of Economics at Koç University, Istanbul, teaching monetary policy and central banking. selvademiralp.com

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1. Low interest-high growth proved unsustainable

The first week of September was rather intense in terms of data releases. The growth numbers that were released on August 31 reflected an 11 percent decline compared to the previous quarter. This number is rather close to the OECD average. If we express the Q2 growth in annualized terms, we reach a 37 percent decline. This can ben comparable to a 31.7 percent decline announced by the US. The inflation number that came on September 3rd points out to an annual inflation of 11.3 percent. Following the inflation release, the recent weakness in TL is likely a combination of several factors: the market’s perception that the low interest rates and stronger TL policies can no longer be maintained.  Since mid-2019, the government prioritized growth and kept interest rates low. Growth had always been the priority of the government.

1- Weaker TL preferred policy

However, differently from the past practice, the consequences of low interest rates policies on the exchange rate was offset at this time. Normally, lowering the interest rates causes a decline in demand for the local currency and weakens it against reserve currencies. This is especially true if the decline in the policy rate is not proportional to a decline in inflation expectations. In Turkey, inflation expectations declined by 5 percent since the middle of 2019. During that time, the policy rate was reduced by 15.75 percent. The consequent depreciation in TL was prevented by tapping CBRT reserves. Over time, CBRT net reserves declined to significantly negative levels. State banks’ open positions reached (and exceeded) legal limits, and no swap agreements could be arranged to re-establish reserves. In August 2020, we have seen a sharp depreciation in TL following the decline in  FX sales while CBRT started. This increased interest rates implicitly. At this time, the government announced that a weaker TL was the preferred policy.

2. Timid, blurry, poor communication, lack of commitment

Anti-COVID stimulus policies were mostly in the form of monetary policy with limited fiscal support. The rapid credit expansion, combined with reserve sales noted in (1) increased the risk premium.  The increase in risk premium combined with sticky inflation started a tightening in market interest rates in July. This was about a month before CBRT started implicit tightening. Thus, the markets once again proved that you cannot implement expansionary monetary policy in the presence of high inflation and support the economy indefinitely.

In fact, it is the tightening in market conditions that forced the CBRT to abandon its low interest rate policies. In order to be successful, however, a central bank should lead the markets, not vice versa. In Turkey, we see the opposite. The central bank comes forth to try to calm down the markets, which is typically an ineffective way.

What’s ahead?

Looking forward, CBRT may need to raise interest rates explicitly. At least to the level of the inflation rate to send a stronger signal about defending the TL and remove market uncertainty. Let’s keep in mind that long term interest rates are priced based on inflation expectations.

Yet, if the central bank takes timid steps to raise the average funding rate within the corridor and shies away from an explicit rate hike, it signals that there is no longer-term commitment to keeping the interest rates at these higher levels. You cannot lower inflation expectations if you cannot commit to a higher policy rate, however. An implicit rate hike is the wrong signal when you are trying to lower inflation expectations and hence lower the long term market rates.  You need to be bold, transparent, clear with your intentions. And show that you are determined to keep the policy rates high until you lower inflation expectations. Yet monetary policy in Turkey is following quite the opposite recipe: timid, blurry, poor communication, and lack of commitment.

3. Slowdown with little room for expansionary policy

The rising number of COVID cases causes concern about the second wave. The credit expansion in the second and the third quarters is expected to yield a V-shaped recovery in the third quarter. However, the abondonment of low interest policies, the consequent slowdown in credit growth, the depreciation in TL, and the rising number of patients risks a slowdown in the fourth quarter with very little room for expansionary policy. These risks are further triggering expectations of a weak TL. And the consequent rise in inflation expectations from the spillovers channel from FX. The inflation numbers that came on September 3rd reflect that both the demand and the cost channels of inflation were in effect. 

Once again, we see that the sectors with the highest monthly price increases are the services, transportation, restaurants, and hotels. These sectors are the hardest-hit by COVID. Yet prices are increasing in these sectors with seasonal improvements in demand combined with a strong cost channel due to FX spillovers and isolation measures. 

4. Health and the economy: the 2nd wave risk

The contraction in growth in the second quarter is not surprising. In our work released in April and discussed in this blog, we had estimated the costs of COVID-19 in the vicinity of -17 percent or more (quarterly), excluding any policy measures. So the accommodative policies as well as the success in containing the virus during the first wave brought this number to -11. This was in line with our expectations. The sizable contraction numbers are not a surprise today. But our research is one of the earliest analyses that pronounced these two-digit quarterly contraction numbers at a time where the annual growth target of 5 percent was not updated. Our goal was to highlight the size of the shock and raise awareness on the issue to develop proper policy measures.

I believe our work served its purpose. Today, many people including myself are expecting a negative growth rate for 2020 as a whole. The imminent threat is the second wave. To prevent a second wave from devastating our lives and our economy, we need to be very careful with obeying social isolation measures. We should be wearing our masks and using hand sanitizers. 

5. TL depreciation, financial tightening, and the 2nd wave

What is striking is that despite this sharp decline in output, the inflation rate never declined to single digits. This reflects the expectations and the cost channel. Looking forward, the inflation rate will continue to limit CBRT’s ability to support the economy because keeping the policy rate below the inflation rate will cause further depreciation in the TL. It seems like TL cannot be supported with reserve sales any further as noted in (1). Markets are most likely pricing these vulnerabilities that (i) TL will continue to depreciate due to ineffective monetary policy (ii) financial conditions will continue to tighten, (iii) a second wave might be emerging, all putting downwards risks on growth.