The central bank did what it had to do

For weeks I have been trying to explain in this column why the Turkish Central Bank must increase its interest rates.
I wrote that the causes of the exchange rate drift were mostly to be found in the current political crisis, but a reaction from the central bank was needed because the wait-and-see policy has been risking further deepening concerns with respect to its independence, as well as increasing the risk of recession. Last week, the Monetary Policy Committee (PPK) contented itself with a very timid reaction that did not convince economic actors at all. One week later, the PPK met urgently and decided to sharply increase its various interest rates. I will later support the meaning of this move and its implications, but the first question to be answered is why the PPK did not make this decision one week earlier. The first inflation report of the year was published last Tuesday and shows clearly that Turkey, as of the end of December, has widely diverged from other emerging markets. Indeed, Turkey's Country Default Spread (CDS) premium (the risk premium) as well as the depreciation of the Turkish lira have reached high levels compared to Brazil, South Africa and Indonesia. The leading market interest rate of Treasury bonds reached 11 percent, well above the de facto interest rate of the central bank at 7.75 percent and at the upper limit of the interest rate corridor. This was a clear signal that monetary policy was unable to determine the market rates. In other words, enough information was available for the central bank to convince its management to strongly react to these facts by using its interest rate as a weapon, even more since massive sales in US dollars have been revealed as inefficient to prevent the drift of the Turkish lira. The central bank's management missed this opportunity and caused deep concerns regarding its ability to operate independently, disregarding the political pressures. So, what happened within a week? I wrote last Tuesday in this column that Ali Babacan, the deputy prime minister in charge of economic affairs, knowing the crucial value of the central bank's independence and knowing also that the central bank may be obligated to react much more aggressively if the depreciation of the lira persists, has been striving to thwart political pressures of some ministers, particularly Prime Minister Recep Tayyip Erdoğan. Mr. Babacan said, “It is absolutely wrong to violate the independent sphere of the central bank.” And I add, “I hope Mr. Babacan will be heard.” It seems that he has been heard, but with some delay. This does not mean that the existing furious debate within the government regarding monetary and exchange rate policies has definitely been terminated. On Tuesday evening, before an unscheduled meeting of the PPK, Mr. Erdoğan made a very critical statement. In response to question on the interest rate policy, he underlined the independent status of the central bank and said that it will make its own decision. Nevertheless, he could not allow himself to add that he is against an interest rate increase and that, in the event of an increase, the central bank management will be responsible for the consequences. We know the outcome. The PPK increased all its interest rates in a dramatic fashion from 425 to 550 basis points. At first glance, this increase seemed a very harsh one. That was my first reaction on Tuesday at midnight. However, the devil being in the details, I nuanced my first reaction when I read in the morning a short communiqué from the PPK. In fact, the central bank decided to use its policy rate instead of its overnight lending rate, which was at 7.75 percent. Since the policy rate has increased from 4.50 to 10 percent now, the central bank's lending rate increased only by 225 basis points. Now, we have two questions to be answered. First, will this harsh reaction be able to decrease the fever of the exchange rate? I think so, but the evolution of political uncertainties must also be taken into consideration. The second question is about the consequences of the interest rate response. In fact, this is a false question. The right one is: What might be the consequences of the interest rate response compared with those of a deeply depreciated Turkish lira? I will try to develop my answer this Saturday, but the faithful readers of this column know my essential point of view: The consequences of a deeply depreciated Turkish lira would have been worse.