Mark Bentley
Feb 10 2018

Turkish inflation slowdown revives talk of rate cuts

A big dip in Turkey’s inflation rate last month is once again raising discussion of possible interest rate cuts by the central bank.

Statements from senior government officials, including Deputy Prime Minister Mehmet Şimşek, who is perhaps the most cautious expert in Turkey’s economic hierarchy, suggest that pressure on the central bank to cut rates may shortly resurface.

President Recep Tayyip Erdoğan is perhaps the most vociferous opponent of using high interest rates to tame inflation among politicians across the world’s emerging markets. Any reduction in rates would come at a time when risks for developing economies are increasing – the Federal Reserve is set to hike its benchmark rates three or four times this year. And Turkey’s economy, already hungry for imports to feed growth, is sucking in more and more goods to maintain the government’s pre-election growth targets, widening its already large current account gap and potentially reviving pressure on the lira.

Şimşek, an ex-Merrill Lynch economist, said this week that the central bank would keep rates high so long as inflation remained in double digits. Single-digit inflation would necessitate “an appropriate monetary policy stance” from the central bank as well as a strong fiscal stance from the government to keep price increases in check, he told Bloomberg in an interview.

Giving courage to the low interest rate camp, consumer price inflation in Turkey slowed to 10.4 percent in January from 11.9 percent in December, a six-month low, the government’s statistics office said on Monday. Price rises among producers slumped to 12.1 percent from 15.5 percent. Still, Turkey’s inflation rate is more than three times the average for emerging market economies.

During the recent years of his rule, Erdoğan has tended to surround himself with economic advisers who agree with his unconventional views on interest rates and growth.

Cemil Ertem, the president’s chief economic adviser, and Economy Minister Nihat Zeybekçi are among the proponents of an unconventional belief, shared by Erdoğan, that cost pressures on industry and imperfect competition, rather than excess consumer demand, are the main drivers of inflation in Turkey. They also concur with Erdoğan’s much-talked-about economic theory that asserts high interest rates cause high inflation, rather than the other way around.

Cemil Ertem
Cemil Ertem

Responding to the latest inflation announcement in a column for Milliyet newspaper on Tuesday, Ertem was quick to point out that the slowdown in price rises vindicated Erdoğan’s economic policies, fast becoming known as “Erdoğanomics”. The government’s measures to help increase manufacturing output – largely through a 250 billion lira ($65 billion) loan guarantee scheme last year, and to tackle food prices increases meant Turkey was winning the battle against inflation, Ertem said. IMF-backed, traditional economic theories that interest rates should be employed to tame price rises were outdated and mistaken, he maintained.

As Güldem Atabay Şanlı, a contributor to Ahval and former economist at UniCredit and Raymond James Securities, pointed out this week, the central bank’s reputation for fighting inflation is already in tatters. And its outlook for inflation – 7.9 percent by the end of the year – is “no more than wishful thinking”, she said. The central bank’s medium-term target for inflation is 5 percent, a goal it has missed for the past seven years.

While the bank was very unlikely to ease its policy during the first quarter, when inflation may slow to single figures, it could succumb to political pressure should it build sufficiently, Atabay asserted, pointing to a meeting called by Erdoğan at the presidential palace last week with central bank governor Murat Çetinkaya,.

CPI

Speaking on his return from the Vatican late on Tuesday, Erdoğan said the central bank, the banking regulator and state-run lenders must “play an active role” in bringing down interest rates. The nation’s non-government banks, he said, were making huge profits by charging interest rates on loans of up to 20 percent, and it was time to end the practice, he said.

Past political pressure means that Turkey’s central bank has already built astounding flexibility into its interest rate policy, so much so that its benchmark interest rate – the repo rate of 8 percent – is now almost defunct as a guide to monetary policy. The bank now has four rates to play with, including its late liquidity window. It raised the latter by 50 basis points to 12.75 percent in December after CPI hit a 14-year high of 13 percent the previous month.

With elections approaching – presidential and parliamentary elections, as well as local elections are slated for next year at the latest – the government will be keen for the central bank to ease its monetary policy to boost employment. The bank could either opt for a straight rate cut, or reduce banks’ average cost of funding by increasing lending at one of its lower interest rates.

Tim Ash, a senior emerging markets strategist at hedge fund BlueBay Asset Management in London, said in a note to investors that Turkey’s military operation in neighbouring Syria meant there was now a high probability that Erdoğan would bring elections forward to this summer, possibly to coincide with the anniversary of the July 15 coup. Ash’s prediction reflected wider speculation that early polls are indeed in the pipeline.

A lot is riding on the elections for Erdoğan – a victory would mean the full installation of Turkey’s new presidential system of government, approved in a referendum last April. Leaving the elections till next year presents significant risk for Erdoğan and his ruling Justice and Development Party (AKP), as the Federal Reserve and European Central Bank unwind their stimulus programmes, potentially stemming the flow of money to riskier emerging markets.

“Erdoğan seems to be building up the nationalist rhetoric/momentum behind him, he will be watching the opinion polls, and perhaps understanding that the economic situation is fragile,” Ash said. “The longer they leave it, the more likely there is a global risk off event this year, which leaves the high beta TRY brutally exposed - and the CBRT then would have to hike aggressively to keep the wheels on the cart.”

A rate cut would indeed present significant risks to Turkey’s economy should global sentiment toward emerging markets turn negative. With the state of emergency, in place since the July 15, 2016 coup attempt, curtailing inflows of foreign investment, Turkey depends on short-term portfolio inflows – i.e. foreign purchases of stocks and bonds – to fund its current account deficit as imports of manufacturing and consumer goods increase.

The current account gap widened by $1.9 billion in November to $4.2 billion, taking the 12-month rolling deficit to $44 billion, more than 5 percent of GDP. Meanwhile, industrial output is climbing and retail sales, announced this week, jumped 5.4 percent in December to a 12-month high. Consumer confidence climbed to 72.3 in January, erasing five months of declines.

The data supports fears among some economists that the economy is overheating, making cuts to interest rates all the more dangerous.