The Central Bank of Turkey should increase its policy rate. The market rate already reached 9 percent.

Last time I raised a question and left it to you to answer. Now it’s my turn. The question was whether the current problems in the financial markets are temporary or permanent. By first I want to correct a mistake in the last paragraph. Though the general framework of the commentary tells it, the mistake might harm the coherence of the story. So, below is the corrected version of the conclusion of the previous commentary:

“In conclusion the FED will 1) first cease additional injections 2) initiate withdrawals 3) increase federal bond rate 4) accelerate the withdrawal process 5) revise the plan under the light of new information.

I did not make up this sequence. The FED already had declared these steps with its exit strategy two years ago. Bernanke’s remarks and minutes of the June meeting of the FED also put emphasis on this exist strategy outlined in July 2011.

These remarks imply that the three years ahead will be a turbulent period for emerging market economies. In the last two months interest rate increased to 9 percent and exchange rate hiked considerably in response to the first step of the FED’s exit strategy. I know I have repeated this several times but it is really important: this first step only means that the FED will cease injecting additional liquidity into the system, an operation it had done on a monthly basis since September 2012. In the past, the main factor that halted foreign fund inflows to and in some cases caused outflows from emerging markets used to be the initiation of interest rate increases by the FED. This step is outlined to start in 2015. Following this step will come an unusual one: the FED will scale down its balance sheet at large (step 4).

Of course some might argue that the distress in financial markets is because of the expectation that interest rate raises will come right after the halting of injections. If this is correct, the process of increasing interest rates must already have influenced the interest and exchange rate outlook in emerging market economies. This would imply that no further consequence will be suffered in the future. It is difficult to be sure about that. But I beg to differ. The period ahead will be an unprecedented one, mainly because the latest quantitative easing process was the largest one in size so far. It is difficult to estimate the impact. But it evidently will not be in the positive direction.

The policy rate must be raised

This is the main reason why I think that the next three years will be challenging for emerging market economies. Under these circumstances, the Central Bank of Turkey should increase its policy rate. The market rate already reached 9 percent. If the turbulence proves to be permanent, interest rate will likely remain high for a long timeframe or even increase further. In this picture, the Central Bank’s raising its policy rate would mean keeping pace with the market.

If my analysis is mistaken and if the turmoil will be short-term, then it is be senseless to raise the policy rate and the Central Bank’s latest actions would not be mistaken. In other words, it is a reasonable option to raise the upper limit of the interest rate corridor, occasionally introduce additional tightening and temporarily raise the policy rate. But to repeat once again, I beg to differ.

This commentary was published in Radikal daily on 16.07.2013