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Enriching the monetary policy framework?
Enriching the framework does not mean – I hope my former colleagues at the Central Bank won’t be offended – making a mess of it.
For now, let’s put aside the developments since corruption probe of 17 December and focus exclusively on the hike in the exchange rate due to the Federal Reserve (FED) decisions, which affected Turkey along with some other emerging market economies. There is no problem if a hike in exchange rate is acceptable under your economic policy. If not, the economy management has to take counter-measures. But keeping interest rates below the inflation is not the appropriate measure for a country in which current account deficit is high, is a major concern and is accepted to originate from consumption growth.
What was the reason of the lira’s depreciation after the FED decision? Before the FED’s famous statement in May 2013, interest on the 10-year US Treasury bond was around 1.8 percent. It reached 2.7 percent after the statement and 3 percent in December when the operation was launched. The rate will most likely increase to 4 percent within a year provided that the US recovery continues. In such climate, Turkey’s financial assets lost their attraction and foreign investors started to invest less in them. With this fall in FX inflow and hence FX supply, exchange rate increases even if FX demand does not. Now add the current account deficit problem to the picture. Interest rate is kept below the inflation in spite of this fact. With the appeal of US bonds increasing, Turkey stands out like a sore thumb, risk perception increases. Together with the rise in FX demand, exchange rate hikes further.
The economy management increases the policy rate slightly - though still below the inflation - and sells vast amounts of FX. But its reserves are naturally limited. It skips the step which initially had to be taken: to set the interest rate right. It is not that it would be a bed of roses when the interest rate is raised. But at least, it would spread the impression that Turkey is a country which manages its economy by the book, avoiding a jump in risk perception about Turkey against other emerging market economies. When the interest rate is right, it is the matter of another debate whether selling FX works or not. It is all about the art of central banking. I would vote against it while some would vote for and it’s completely okay. But it is not apprehensible why policy rate is kept at such low levels in this climate. It has nothing to do with the art of central banking. It is clearly against the book as it escalates the economic riskiness of Turkey.
Now rewind the story and add all that has been going on since 17 December: exchange rate reached the sky. The central bank sold large amounts of FX in response. Yet the exchange rate kept on climbing as the risk perception against Turkey escalated. Moreover, the economy management did not play by the book – it did not increase the interest rate in time and it might be too late for doing that now. Because rise in interest rate due to the rise in risks does not help you to limit the rise in exchange rate. Interest rate has to be increased without pushing risks up as well. In fact, an increase in the interest rate due to risks is an indicator of declined demand for lira assets. If you didn’t raise the rate when the coast was clear despite all the complaints about high current account deficit and high consumption cited as the reason, raising the interest rates now might be considered a “panic move” and intensify risks further. This sure is just a possibility; but it might happen.
Conventional monetary policy is the compilation of the theoretical knowledge and central banking experiences culminated in years. You might sure want to renew and enrich the conventional framework. It is but natural particularly given that the world has already embarked on such quest. But enriching the framework does not mean – I don’t want to upset by former colleagues at the Central Bank, but I could not find a more appropriate way to describe the situation – making a mess of it.
This commentary was published in Radikal daily on 07.01.2014