One immutable rule in developing nations is the existence of politicians who palpably need fast economic activity to keep its voter base strong. In Turkey, this is absolutely proven to be right by the President Erdogan whose repeated pro-growth economic views are well known ─which include very dissenting opinions to generally accepted theories such as high interest rates cause high inflation. It is also not a secret that Turkish President has been piling pressure on the central bank and other financial institutions and pushing for lower interest rates.
Well, the chart above tells us an interesting story (might be even more interesting for the Presidential economy team). The colorful lines show the evolution of commercial lending and deposit rates implied by Turkish banks, and lines in grey show the policy rates (or average cost of funding) of Turkish central bank and the inflation rate where the lighter one shows the ‘real cost’ of money and the dark one is the inflation. Important point to gleam from the chart is that Turkish central bank had clearly maintained tight monetary policy as it has turned more and more accommodative following the global financial crisis.
Now here is thing: As Turkish central bank loosens its monetary policy, banks become more dependent on collecting deposits and deposit rates fall to extremely lows that they even provide negative returns in real terms as they remain below inflation rate. On the other hand, commercial lending rates, that could be considered as a critical source for the economy, do not track other the so-called policy rate as much as deposits do, and create a huge spread (between lending-borrowing) for banks to benefit (also need to note the QE impact here). Eventually, ‘interest rate lobby’ seems to have enjoyed the low rate environment much more than some think it would have.
Turkey has been an interesting experience for economists in many aspects. A central bank keeping the real interest rates extremely low in a period when the country suffers from savings gap and high inflation may be among them, despite a good economic performance.
Pretending that the central bank is the only game in town is inherited by the world of quantitative easing, where developing economies are besotted with a cheap money which has been in place for almost a decade. That decade is over and audience does not have any opportunity for a curtain call.
So far you have read a story which you are probably familiar with. From now on, we are solicitous to provide some insight supported by some data about how effective Turkish central bank has been in shaping the credit markets through interest rates. At this point, we look for correlations between loan rates and the average cost of funding rate, which was originally made in Turkey, through a system called “interest rate corridor” in which the central bank can determine the effective fund rate in a considerable wide margin.
The chart above show the 36-week trailing correlation between the effective interest rate between implied by the central bank and the rates for direct consumer, mortgage, commercial lending and deposits.
There has been cycles when apparently central bank lost its control over credit markets. The first cycle, in our view, was solely based on this unorthodox monetary policy framework as discussed above. Having said that, the following two cycles are products of banks’ weakening appetite for lending growth.
We attach important to the last two because it shows when loans to deposit rates when through the roof, banks deliberately lift their rate that loans and deposits carry without a tightening signal for the reserve bank. That is simply how to be functionless in determining the interest rates for the banknotes you issue. This view is also supported by lead-lag analysis that suggests loan growth surprisingly lead interest rates.
Since 2006 Turkish central bank has officially been in pursuance of price stability after reforms such as law amendments regarding the formation of the bank differ the way the bank function. Until 2009, the bank irrefutably had been on the path to achieve price stability. However, in the following years, we have seen the bank using non-conservative tools to reach the desired results that have unsurely included the price stability.
Over the past five years, Turkish central bank has failed to lower the inflation rate to 5%, which it set a long-term target for the price stability, while the rest of the world has struggled to slay deflation. According the December 2015 inflation report, consumer price index in Turkey increased by 8.81% y/y. Food prices have been heavily accused for the higher than expected increase which were up 13.7% (nonprocessed foods). This was highly elusive given the country’s food self-sufficiency. But, more importantly, I-index which excludes food, drink, and energy prices (or core inflation as some say) rose by 9.5%, which clearly reveals the central bank’s painful failure.
Tightening was simply what was expected from the central bank in such cases. Turkish central bank referred to the U.S. Federal Reserve’s policy normalization as the trigger to simplify its own monetary policy. However, after the Fed move in December, Turkish central bank kind of postponed its own normalization process, referring this time to high volatility in the financial markets as a prerequisite. As this was one of the worst cases ever happened in the history of communication in central banking, its credibility got shredded again, worsened already dismal expectations. Now, according to the participants of the survey of expectations, a Turkish central bank reaching its inflation target is unlikely to occur in two years.
It is a fact that Turkish central bank has become less and less resistant to political pressures, as concerns about the bank’s independence have remarkably risen. If so, one should argue that the central bank has also lost its influence on the rates in the credit markets. In other words, politicians’ repeated calls for lower rates to boost growth has resulted in or are to result in with a monetary policy that lacks ability to impact interest rates. See the chart below.
At this point the famous issue of output-inflation trade-off springs to mind, and what is so interesting about the Turkish case is that the central bank has presumably managed to fail in both sides. This all has been a central-bank failure of epic proportions.