Posted on

This Time It is Different: Turkey’s Negative Real Interest Rate Policy

erkan kilimci

Negative real interest rate policy is common in advanced economies. The idea behind negative real interest rate policy is to keep financial conditions loose enough to stimulate economic activity. Turkey re-implements negative real interest rate policy when inflationary pressures are building across the economy. The question is not if economic agents will ask for more money at lower cost but how will they use it?

What is Cantillon Effect?

The process of money creation is no more a secret. Banks create money whenever they make a loan. There is no physical or natural constraints on how much money is created.

A Cantillon effect is a change in relative prices resulting from a change in money supply, which was first described by 18th-century economist Richard Cantillon.

According to Richard Cantillon, the beneficiaries from the expansion of the money supply are the first recipients of the new money. As new money is created by banks, those who have the best access to bank credit benefit the most. 

Inflation expectations in Turkey signal for high money demand if Richard Cantillon is correct in his assumptions.

Orthodox Monetary Transmission Mechanism Under Inflation Targeting Regime

Although there is no quantity constraint on money creation, economic agents shift their money demand reflecting their expectations in the price of money. Central banks manipulate short term interest rates to manage expectations on future price of the money. This is basically called monetary policy transmission.

Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates.

Monetary policy can also guide economic agents’ expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.

Transmission mechanism of monetary policy
Stylised illustration of the transmission mechanism from interest rates to prices

During the global monetary policy normalization, Central Bank of Turkey followed positive real interest rate policy in line with inflation targeting regime play book until 2020. In 2020, Turkey implemented negative real interest rate policy which was halted after sharp depreciation in Turkish Lira.

Negative Real Rate Policy in Turkey

Once again Turkey will apply policy rates lower than inflation rate under new policy framework. According to the recent communication of the Central Bank, new policy framework will help the current account to give surplus and accumulation of international reserves.

The improvement in annualized current account is expected to continue in the rest of the year due to the strong upward trend in exports, and the strengthening of this trend is important for the price stability objective.

Briefing on 2021-IV Inflation Report

Negative real interest rates are expected to stimulate the corporate sector to produce more and overcome the supply side problems in the economy.

The tightness in monetary stance has started to have a higher than envisaged contractionary effect on commercial loans.

Press Release on Interest Rates (21 October 2021)

New Money Demand is On the Rise

Since the Central Bank implemented new policy framework, economic agents started to increase the demand for new money. I will use annualized Turkish Lira loan growth momentum as the proxy for new money demand. Annualization is an easy way of describing momentum. To annualize a number, multiply the shorter-term rate of return by the number of periods that make up one year. Below chart is a simple annualization of Turkish Lira loan growth rate. Calculation is based on 4 week average multiplied by 52. 

As we know that monetary policy works with an overall lag of 12 to 24 months, or even longer. Outcomes of new policy framework will be more observable next year. At the moment markets priced these outcomes with higher inflation risk premium and higher cost of risk.

Posted on

A Tale of Two Inflations in Turkey: Import Prices and Food Prices

hand, keep, magnifying glass

One of the favorite explanations for high inflation is exchange rate pass through. Central Bank of Turkey spares an important part in their investor presentation to this relationship.

Interestingly this relationship is very closely monitored by currency traders as well. Since Central Bank communicates with the markets from the perspective of exchange rate pass through, currency traders expect Central Bank to react depreciation of Turkish Lira at historical levels. This relationship of Central Bank with currency traders can be simply explained as: “scratch my back and I will scratch yours”. Central Bank gets rewarded by the economists as far as currency traders continue to make profit. But unfortunately this relationship is from the beginnning to the end very pragmatic. And it ends up when currency traders decide to unwind their position.

It is sometimes argued that increasing globalisation and openness to trade has exerted downward pressure on inflation in developed countries by, for example, reducing import prices. It is just the opposite what Turkey experiences. On the other hand food inflation is totally a different story. Food prices are composed of two groups: processed and unprocessed food products. Unprocessed food products are goods such as fruits, vegetables, meat and fish that are offered for household consumption without significant processing, whereas processed food products are sold after processing and completion of a value-added chain.

What makes food prices so rigid ?

The high degree of climate dependence in production, high number of intermediaries in the supply chain, uncertainties surrounding agricultural subsidies, concentration of agricultural production in certain geographic areas, fluctuations in external demand, price structure of export goods, consumption pattern.

In 2021, it looks like that we will observe lower inflation in the coming period, thanks to the real appreciation in Turkish lira and seasonal behaviour of food prices. As tight monetary conditions remain intact, this pattern will become more visible in inflation as well.

Likewise food price seasonality, short term money managers also have its own seasonality. Both of the factors have been supportive in efforts to manage inflationary forces so far. The question remains what will happen when conditions become unfavorable?

Posted on

Underlying Trends in Turkish Economy under new Economy Management

city, buildings, night, erkan kilimci

Recent macroeconomic regime shift in Turkey resulted in meaningful adjustment of risk pricing in the financial markets. Portfolio flows into money markets and capital markets considerably supported Turkish Lira assets. On the other hand, foreign currency demand has been moderated recently.

New orthodox policy framework regime will be able to control credit growth under the ongoing weakness in overall economic conditions, especially domestic demand . Recent underlying trend in Turkish lira credit momentum is strong enough to normalize abnormal loan growth during the first quarter of 2020.

New economic management highlights the fact that inflation is still far from the 5 percent target and tight monetary policy will be implemented until inflation is under control. This kind of communication is good to attract some attention. Cyclical nature of some items even will help to achieve some sort of price stability.

FX pass through is the principal factor that explains recent inflationary pressures. Ongoing real appreciation of Turkish Lira is underway and this will help the inflationary pressures to subside going forward. As far as the global risk appetite allows, it is possible to see Turkish Lira further strengthening in real terms. Most of the prices in financial markets are mean reverting. Even without intervention, prices revert to its long term averages. As expected Turkish lira managed to gain value from historical low levels. Fast money captured the opportunity to profit from interbank dealings with Turkish banks.

Consumer confidence increases with the appreciation of Turkish Lira. Firms unwind fx hedges and increase fx borrowings as a result of lower risk premium and central bank put to control foreign currency. As it has been observed in the previous episodes current account deficit increases even under tight financial conditions.

Fast money positioning and tight monetary policy are not a remedy to fundamental problems of Turkish economy. Although external vulnerabilities require moderate level of money creation, lack of liquidity will create its own problems.