The proposal that “if interest rates fall, inflation will decrease” is not misleading; however, it depends on some conditions and the kind of ‘interest rate.’ An economy providing necessary conditions implies that it moves on a healthy path. What are these conditions? And which interest rate, as well as whose interest rate are we talking about lowering?
Treasury borrowing rate
Let us start with foreign borrowing. The budget is in deficit; it needs to be financed. A significant part of the financing is provided by foreign currency borrowing from abroad.
Consider a US pension fund calculation to purchase the dollar-denominated bond issued by the Turkish Treasury. To simplify, let us assume that the second option of the US pension fund is to buy bonds issued by the US Treasury with the same maturity. If the fund buys the ten-year US bond, it will earn 1.5% each year. Those who manage the pension fund consider that the US bond has no risk.
However, Turkey is perceived as a risky country in international markets. Therefore, if the fund bought the ten-year bond of the Turkish Treasury, it would apply to a financial institution that “insures” this bond. This institution is currently asking for a 4.5% insurance premium (450 basis points CDS) for the Turkish Treasury bonds. This means that to purchase the Turkish bonds, the pension fund would require at least a 6% interest rate (1.5 plus 4.5).
If the perceived risk were reduced, the insurance premium (risk premium) would also lessen. This very simplified calculation tells us that if the risk perception regarding Turkey abates, the foreign currency borrowing interest rate of the Turkish Treasury (6%) will also decrease.
Lowering the risk
Turkey’s risk depends on the state of its economy, the economic policies that are implemented and announced to be implemented, and its foreign policy. Let us put foreign policy aside.
Policymakers have to reduce whatever increases the sovereign risk. If it stems from a high budget deficit, the Treasury has to borrow heavily. Excessive debt poses several serious risks. So policymakers need to fix the budget. The budget can be sound, whereas banks can be in trouble. In this case, policymakers need to strengthen the banks. If the monetary policy is lax, policymakers should make it sound. The bottom line is that the factors that increase the risk usually lead to high inflation in that economy. In Turkey, under these conditions, demand for foreign currency increases leading to a significant depreciation trend. The end result is a considerable increase in inflation.
Consequently, if policymakers reduce the risk, they can lower the interest rate, and inflation will decrease in this environment. In other words, with low risk, it is highly possible to have a low-interest rate and low inflation.
Deposits and loan interests
Let us review it from the saver’s viewpoint.
Should she renew her television or deposit that money into a savings account? Let us simply examine: If she bought a TV now, she would pay 5000 liras. Let the one-year deposit interest be 10% (net). If she deposited 5000 liras with a one-year maturity, she would have 5500 liras by the end of the year. If the TV price increased by less than 10% after a year, she would profit from this decision; it would be worth the wait. However, if TV inflation were over 10%, she would not be able to buy that TV a year later. For instance, if the TV inflation would be 20%, the TV price would be 6000 liras a year later. She both had to wait a year and had to pay extra 500 liras to buy that TV.
Consequently, three factors are very influential in her decision:
1. How much will inflation be, that is, how much will TV price increase in a year?
2. What is the deposit rate?
3. There is a return expectation of making it worth the year’s wait. That is, let the current deposit rate both cover TV inflation and leave her some profit. Therefore, the third determining factor is the real (inflation-adjusted) interest rate.
The consumer does not know the first of these three factors. She needs to form an expectation of inflation by the year-end. She would figure out this expectation by reviewing what economists, whom she believes in, declare. The second factor she would know is the current one-year deposit rate. The third is how much real interest rate would satisfy her. Add up the inflation expectation and the real interest rate that will be sufficient for her. You will find the deposit interest rate she would demand. If the deposit interest rate offered by the bank were equal to or higher than this, she would deposit her money in the bank account rather than buying a TV. If not, she would prefer to buy the TV.
Lowering expected inflation
Suppose you implement an economic program that would reduce the expected inflation rate. In that case, the deposit rate that the saver would be willing to accept will decrease right away. Moreover, if the interest rates on the deposit collected by the bank decrease, the loan interests also decline. Since inflation would fall after a while, depending on the program implemented, not immediately, the result is clear: Low deposit interest and loan interest rates, low inflation.
It is possible to include the risk factor or holding foreign exchange denominated assets alternative for the depositor, or make similar calculations for the business person who would make an investment decision. Nonetheless, not necessary here.
I assume I have explained my point clearly enough. In all of these examples, both interest rates and inflation decline. Therefore, a scientist who will statistically analyze these observations can establish a causal relationship “if interest rates fall, inflation will decrease.”
Which interest rate?
Bond interest rate, deposit interest rate, or loan interest rate. None of them are the Central Bank interest rates. The interest rates determined by the Central Bank are either overnight or weekly interest rates. However, what is critical in the above-given examples for the decisions of economic agents are the ten-year bond interest rate, one-year deposit interest rate, or five-year loan interest rate, not the Central Bank policy rate. Here comes the crux of the matter. The implemented economic policy and obviously the implemented monetary policy should lower the risk premium and inflation expectations.
The main task of central banks in almost all countries is to fight inflation. If a central bank performs in accordance with its mandate, it will reduce the risk premium and long-term interest rates. That means that if it is needed to raise the policy rate, it increases; if it is required to lower it, it cuts. Eventually, the risk premium and long-term interest rates will decrease. So will inflation.
What is the big deal?
The Central Bank has lowered the policy rate by 400 basis points since September 23, while inflation was on a rising track which eventually increased the risk premium and long-term interest rates. In other words, the interest rates, which are essential for the economy, did not decline since the Central Bank has lowered the interest rates.
The big deal is to lower the market rate, not the policy rate. It is a piece of cake to reduce the policy rate; just by making a decision. Nevertheless, achieving the latter requires strenuous effort.