Today, let’s look at the Turkish economy. The monetary policy in most economies is anchored by a specific inflation target. Targeting price stability has so far served both developed and emerging markets. Until supply-side problems in the supply chains and labor markets began to spin up rapidly rising prices, inflation in the leading economies was well below target, and the question of what to do in such situations would sooner or later return.
Twving-century American economist Irving Fisher had the answer. Economic orthodoxy prescribes that when inflation exceeds the target set by policymakers, central bankers should raise nominal interest rates. Rising interest rates hold back debt and spending, thereby cooling the economy and curbing inflation.
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However, Fisher believed that when inflation was too low, central banks should raise their targets for nominal interest rates. He argued that there was a positive correlation between nominal interest rates and inflation. This relationship, known as the Fisher effect, is clear from economic data. Modern macroeconomists interpret this causality as moving from inflation to nominal interest rates.
Turkey is the first country to test Fisher’s theory with a fundamental distortion. Turkish officials believe that high-interest rates cause inflation and argue that causality is going in the opposite direction. The Turkish authorities say that a reduction in interest rates should dampen inflation. After all, as Fisher argued, the nominal interest rate is the sum of the real interest rate and future inflation. If the real interest rate is constant, then a long-term decline in the nominal interest rate will lower inflation. The impact of the reduction in the nominal interest rate on the real interest rate will disappear in the long run.
Neofisherian Turkish economy experiment
However, such monetary neutrality is lacking in the short term, so a decline in the nominal interest rate also reduces the real interest rate. This is hurting domestic and foreign savers, a severe problem for Turkey, which has a persistent current account deficit to finance its economic growth.
Given that the real interest rate is negative, this neo-Misherian Turkish experiment will exacerbate inflation. A country that needs domestic and foreign savings to finance rapid growth cannot offer negative returns to the savers concerned.
The government recently announced a new policy to encourage domestic savings: If the lira’s decline against major currencies exceeds bank interest rates on short-term deposits, the government will pay the difference to lira deposit holders. For example, if banks payout 15% on 12-month lira deposits and the lira devalues by 20% during the same period, the government will compensate depositors.
While this policy will protect domestic savers and prevent them from leaving the lira, it will do nothing to encourage foreign savers. The resulting outflow of foreign capital will accelerate the lira’s devaluation and continue to spin inflation. And because the chosen policy transfers all currency risk to the government, it will weaken public finances and ultimately lead to debt monetization.
Fatal error in the model
Why would the government even want to introduce this more expensive alternative to tighter monetary policy? The answer is clear. Turkey’s short-term growth model is on credit, which requires the country to borrow at low-interest rates.
However, the role of foreign capital flows reveals a fatal flaw in the model. If a country needs external financing and draws on its savings from foreign savings, capital flows are a more critical factor in short-term domestic lending rates than the monetary policy rate – a phenomenon known as “short-term rate decoupling.” This is because domestic banks’ financing depends on international financial markets.
After adjusting for the expected devaluation, there should be no difference between the lien and dollar deposit rates for foreigners lending to these banks. But this is not the case from the Turkish point.
If foreign institutions lend in lira, they charge a risk premium, which has now risen due to the devaluation of this currency. And if they borrow in dollars, they charge a premium for insolvency risk, which has also increased. A good example is the recent record-high spreads on Turkish credit default swaps. As foreign investors leave the Turkish markets (or charge higher risk premiums for remaining), currency devaluation and inflation will intensify.
Inflation must be targeted appropriately to defend the lira and revive capital inflows. If inflation exceeds the target, monetary policy rates should rise to cool the economy and stabilize prices. A small open Turkish economy, which finances its growth from foreign savings, cannot fight inflation without a credible monetary policy and thus stop devaluation. The Neofisherian approach will not replace it.
