U.S. inflation and Turkey's monetary policy

Turkey's economic mismanagement by unqualified people and its broken political system will present greater challenges to the country’s economy during the deep financial changes that the world is about to go through. 

U.S. consumer price inflation (CPI) and producer price inflation (PPI) data for April, published this week, marked a turning point in the return of global inflation. April CPI accelerated to an annual 4.2 percent and core CPI reached 3 percent. PPI climbed to 6.2 percent and core PPI to 4.6 percent.

The reasons behind higher inflation are rising commodity prices, the return of deferred domestic demand, logistical difficulties and, most importantly, giant incentive packages by the U.S. government. Stimulus in the 2008-2009 global financial crisis was directed at financial institutions. This time around, the target is consumers. This key difference is one of the biggest reasons why investors fear that the uptick in inflation will persist.

The U.S. Federal Reserve has been saying for some time that inflation will nudge higher but that the spike would not last beyond 2021.  It has cited six main reasons for the temporary increase.

The first is that inflation expectations stand at 3.4 percent for this year, while five and 10-year expectations of 2.7 percent do not indicate a deterioration. The second reason is that the millions of jobs lost during the pandemic have not been replaced, with nearly 8 million more people needing to find work, which is suppressing wage increases.

The third reason is that the rise in commodity prices is limited to a few items. Fourthly, the Fed says that a surge in popularity of online shopping limits price increases. The fifth reason is that big shopping chains do not want to reflect a rise in production costs on consumers. Finally, the Fed says that the base effects of inflation, which slowed sharply in April-September last year, are pushing this year's figures upwards.

Even assuming that all the Fed rhetoric, which some economists disagree with, is true and we accept that U.S. inflation will slow to below 3 percent again in the next five years, the current trend shows the challenges Turkey’s economy faces in the short term. 

The April U.S. inflation figure of 4.2 percent is probably not the peak. Headline CPI may accelerate towards 6 percent by mid-year and then return to the 3.3-3.5 percent range by the end of 2021. With only April data, the world's stock markets were turned upside down, while the Dollar Index turned upwards again. Ten-year U.S. bond yields rose to 1.67 percent within hours from 1.47 percent. The lira weakened to 8.5 per dollar from around 8.3 on a day when the Turkish markets were closed.

Interest rates on U.S. 10-year bonds will rise to 3 percent and probably a little higher due to the surge in inflation. This will bring down asset prices in the markets, put significant pressure on developing country currencies, strengthen the Dollar Index and bring forward the Fed’s policy tightening steps and rhetoric.

But in Turkey, monetary policy is taking shape in an alternative reality.

The sale by the central bank of $128 billion in foreign currency reserves during 2019 and 2020 to support the lira was in vain. The reduction has diminished Turkey’s net forex reserves to a negative $47 billion, leaving the lira vulnerable to external shocks.  But the shocks in Turkey’s monetary policy are far from over. The first such shock occurred in March with the dismissal of respected central bank governor Naci Ağbal and the arrival of Şahap Kavcıoğlu, who was hired to act on the orders of President Recep Tayyip Erdoğan. Despite interest rates of 19 percent, the highest in major emerging markets outside of crisis-hit Argentina, the lira has lost more than 10 percent of its value since the appointment.

Even if headline CPI in the United States slows after accelerating, it will not return to previously low levels. But Turkey's central bank is seeking an opportunity to cut the policy rate as headline CPI is expected to ease from 17.1 percent towards 15 percent, at best, in the fourth quarter.  

With the change of tide in the global economy, the pressure of a strong dollar and rising U.S. bond yields, the lira is set to depreciate towards 9.5 per dollar by the end of the year. In every policy text announced by the central bank under its new administration, we see that the foundations for an interest rate reduction are being prepared. Blind to the above simple facts, the central bank appears tempted to cut the policy rate in September due to base year effects on inflation. Such a rate cut would no doubt fuel the fire of troubles in Turkey’s financial markets and economy.

Would it be possible for the central bank to raise interest rates, given the reality of accelerating U.S. inflation? Can Turkey’s central bank under Erdoğan’s control do its job independently? Can Kavcıoğlu achieve his mission of creating a lower interest rate environment for Turkey’s troubled industrial sector in the run-up to elections when Turkey’s economic problems stand out as the sole reason for the loss of support behind the governing AKP-MHP alliance?

If the answer to these questions is an easy “yes”, there is not much to be afraid of. There will be no more problems for Turkey other than the impact of upcoming turmoil in the world’s financial markets, which will affect all emerging economies. Yet, if the answer is a solid “no”, if there is just the slightest inkling that the central bank could risk lowering interest rates ahead of elections, slated for 2023, despite global inflationary pressures, then there is much to fear about the future for Turkey’s economy.