It’s the inflation, stupid!

The slogan that got President Clinton into the White House back in 1992 has become a mantra since, guiding many politicians around the globe in their lust for power.

Focusing on the miseries of the working class has turned out to be the ticket to government, just as was the case for President Recep Tayyip Erdoğan in Turkey’s 2002 general election.

During the past 15 years, first as prime minister then as president, Erdoğan was well aware of the advantages of a “smoothly running” economy. Thus, his team placed special emphasis on sensible and often credible macroeconomic steering. The fine balance Erdoğan created between prudence and populism pleased both foreign investors, who poured tens of billions of dollars into Turkey, and voters, as the middle class expanded and strengthened.

However, the marginal cost of staying in power increased over time and the government engaged in efforts to consolidate its power. Emphasis thus shifted to prioritizing stronger growth over macroeconomic balance; and then to keeping society polarized to bolster support further.

Just as polarizing society was a result of criminalizing “opponents,” stronger economic growth was a function of the Central Bank of Turkey (CBT) being coerced into relaxing its grip on inflation. And, of course, the government also took advantage of the huge ocean of liquidity in global markets since 2008, which helped it boost growth while keeping inflation manageable.

Turkish Lira vs US Dollar (Source: Trading Economics)
Turkish Lira vs US Dollar (Source: Trading Economics)

Things now look to have changed profoundly.

The start of the week brought news that the central bank would be withdrawing TL5.3bn (USD1.37bn) of lira liquidity from the market in exchange for USD1.4bn of dollar liquidity through a change in reserve requirements. The move was part of the bank’s “quest” to support price stability after the lira dropped rapidly against the dollar. The central bank argued that recent price formations in the lira were “inconsistent with the economic fundamentals” of Turkey.

Very well. However, is that really so?

Turkey Core Inflation - yoy, percentage (excl. energy, food and non-alcoholic beverages, alcoholic beverages, tobacco and gold) (Source: CBT)
Turkey Core Inflation - yoy, percentage (excl. energy, food and non-alcoholic beverages, alcoholic beverages, tobacco and gold) (Source: CBT)

Last week, the government released October inflation data. To the agony of Turkish residents, consumer price inflation (CPI) crawled up to 11.9 percent, reaching a nine-year high. The pace of inflation was even greater in the sub-segments of food, housing, and transportation. Producer price inflation (PPI) also reached a nine-year record of 17.3 percent, with manufacturing-sector inflation standing at an astonishing 18.9 percent.

The most disturbing thing of all is the level and trend of core inflation. The core index (which excludes energy, food and non-alcoholic beverages, alcoholic beverages, tobacco and gold) increased to 11.8 percent in October, almost doubling over the past 12 months.

The rather tragicomic aspect of this mess is that the central bank reiterated that it was committed to employing “tight monetary policy” in its quarterly inflation report, also published last week. But please note: the central bank’s average funding rate was 11.96 percent as of Nov. 1 versus CPI of 11.9 percent and PPI of 17.3 percent. Last but not least, the bank still maintains that it is targeting of 5 percent.

Really, how could anyone call this a credible way of targeting inflation with a “coherent” monetary policy, as the bank maintains. Rather, it undermines the success, earned with blood, sweat and tears, of bringing inflation down from 29.7 percent in 2002 to 6.2 percent in 2012.

Central Bank of Turkey Fund Rates (Pink Line=WA Funding Rate) (Source: CBT)
Central Bank of Turkey Fund Rates (Pink Line=WA Funding Rate) (Source: CBT)

Current inflation levels, the central bank’s supposed “tight monetary policy” and everlasting pressure to lower interest rates as the 2019 elections approach mean just one simple truth: as of now, the bank has lost control over inflation dynamics, dollarization is on the rise and so is price rigidity.

From this point on, it will be difficult for the central bank to reverse deteriorating inflation expectations. The current trend in core inflation, the cost burden on manufacturers – which is soon to be reflected on consumers – and the bank’s recent failed efforts to cap the lira’s slide, mean that unless it makes a U-turn toward common sense, inflation is heading to 13-15 percent over the next 12 months.

Not mentioning the need for reforms to overcome structural rigidities. Getting serious in tackling high inflation requires tight fiscal and monetary policy, both of which we lack in Turkey given escalating populism since 2013.

What is absent is obviously political will. Erdoğan has long argued that high inflation is a result of high interest rates. Thus, according to his logic, which defies Macro-101, interest rates should be lowered to fight inflation. The central bank, whose autonomy and authority have been a topic of debate for some time, appears helpless when it comes to such political intervention.

However, as said by Twain, truth is stranger than fiction.

Although the relationship between money and prices is broken in many economies due to deregulation and technological change, the central message of Friedman’s proposition remains basically intact. Inflation is a monetary phenomenon, eliminating other fictional possibilities. Price stability is a medium- to long-run notion where sustainability is the key. In Turkey’s case, we definitely have high inflation, it is easily identifiable as an unsustainable trend, therefore this calls on the central bank to know what it should do in a technical sense. That is to lower both inflation and the level of liquidity in the markets, if one can’t increase the level of production rapidly.

Put more clearly, unless the central bank of Turkey gets serious on inflation and raises interest rates to the tune of 200-400 basis points; it will not be able to prevent consumer prices from sticking in double digits, within the 13-15 percentage range.

However, even such a severe rate hike may not be enough. To lower prices on a sustained basis, cooperation with fiscal policy makers is vital. Unfortunately, given the government’s recently unveiled fiscal objectives in its medium-term plan, there is no room for the fiscal austerity that could have helped the central bank lower the inflation rate in Turkey.

So, Turkey is heading into 2019’s presidential and parliamentary elections with a pace of economic growth that is more and more of a burden on inflation with each marginal increase. Thus, perhaps someone should warn the government that troubles in the economy are not related to growth this time round, but to inflation, and those troubles could probably alter the election outcome.

Central Bank of Turkey Inflation (yoy percentage) (Source: CBT)
Central Bank of Turkey Inflation (yoy percentage) (Source: CBT)