Central Bank May Start To Feel The Pinch Again

The Central Bank of Turkey has decided to keep the benchmark interest rates unchanged in the latest meeting of its Monetary Policy Committee (PPK), held on Thursday, in line with the expectations of the markets. For me, keeping the rates unchanged means that the bank actually decided not to raise them rather than to rule out the option to lower them.

The PPK praised the macro-prudential measures the government had taken earlier in the year while underlining the contributions of the central bank's unwavering stance in carrying out the monetary policy of the country. I am sure many economists have met these boastful statements with a sarcastic smile on their faces.

Still, government pressure on the central bank to lower inflation rates seems to have cooled down in recent weeks, especially after Ahmet Davutoğlu took the office of the Prime Ministry. He is probably not talking about economy-related subjects, possibly because he does not feel competent enough with the technicalities, unlike President Recep Tayyip Erdoğan, who surely has vast knowledge on the discipline, so much so that he even challenged the pillars of the science of economics.

I want to believe that the new government's preference to remain mum on the monetary policy practices of the central bank is due its comprehension of the dire consequences of such interventions, which may compromise the central bank's independence and in turn dent its prestige. The obvious result of such a loss of prestige is ridding the bank of one of its most important weapons to combat inflation: credibility, also known as the power of administering expectations, and I really want to hope that Davutoğlu was convinced about it.

Leaving the benchmark rates intact is understandable in light of recent falls in commodity prices as well as the plummeting costs of oil, which will inevitably result in the decline of production costs in Turkey and the current account deficit. There is no need to say that these all indicate downward pressure on inflation.

Notwithstanding, such provisional and apparently contextual oscillations in energy and commodity prices in international markets don't promise the formation of any long-term trend. Besides, it is common knowledge that inflation in Turkey is primarily demand-driven and can only partially be classified as cost-push. So, I think it would not be wrong to assume that cost-related developments will have limited impact on the future course of inflation rates. Another point which must be considered is that Turkey has four times the average inflation rate of developed economies, and its inflation is twice that of developing countries.

There is another side to this story. The central bank, for some time, has not been directly changing interest rates but has been trying to get this result through indirect methods, a kind of engineering that proceeds through trial and error. I will not go in the technical details, but let me mention a few of them as examples to make this point clearer.

The reserve option mechanism made it lucrative for banks to deposit their reserve requirements in gold and foreign exchange. But after realizing that this system, which was designed as an auxiliary stabilizer mechanism for the money markets, does not work properly in times of capital outflows, the bank announced this week that it will start paying interest for reserve requirements that are deposited in the central bank coffers in liras.

This will likely bring down the funding costs of the lenders in Turkey by around 1 percentage point. In other words, the loan costs will come down. Similarly, the bank decided last month to replace the repossession tender valued at TL 25 billion with another one, the value of which was TL 20 billion. That is to say, it reduced the liquidity by TL 5 billion and hence pushed the funding costs up by some 30 basis points. The bank was trying to tame the surging lira by indirectly raising the interest rates of the banks and hence avoiding a possible bashing from the government.

Political power does not care about the technical details or laws of the economy. “It's the economy, stupid” best describes their straightforward approach to it. An economist's struggle to explain that there are obvious barriers to reach desired consequences is understood as a confession of incompetence. This government may even see it as a coup attempt.

There is a general election ahead and economic conditions are a lot more effective in decreasing the ruling party's votes than the fiercest opposition by opposition parties. So the government will likely again start to pile up pressure on the central bank to lower inflation. It seems that the cunning methods of the central bank to modify market interest rates will no longer be enough to convince the politicians.

İbrahim Türkmen (Cihan/Today's Zaman)