Limits of monetary policy

The Monetary Policy Committee (PPK) of the Central Bank of Turkey decided to cut interest rates by more than expected during the monthly meeting held on Tuesday. The one-week repo rate (the policy rate) has been lowered from 5.5 percent to 5 percent, while the upper limit of the interest rate corridor (the lending rate) and its lower limit (the borrowing rate) have been cut, respectively, from 7.5 percent to 7 percent and from 4.5 percent to 4 percent. The size of the cuts surprised the business community as well as market players and provoked a hot debate among economists regarding the goals pursued by the central bank and its ability to reach these goals through these strong interest rate cuts.
Governor Erdem Başçı I think there is a large consensus regarding the main goal: The central bank wants to prevent further appreciation of the Turkish lira which has already crossed the red line set by itself. The central bank announced recently that the real exchange rate index would be entering the alarming zone over 120. The index is already there. Moreover, it will certainly be continuing to increase since the Turkish inflation rate is higher than its trading partners. The appreciation of the Turkish lira threatens the so-called “balanced growth” and the financial stability that is so intensely desired by the central bank through losses in the competitiveness of Turkish exports and excessive credit expansion. The following assertions from the MPC release should be underlined: “Recently, there is a reacceleration in capital inflows and credit growth hovers above the reference rate. The committee indicated that, in order to balance the risks on financial stability, the proper policy would be to keep interest rates low while increasing foreign currency reserves via macro prudential measures. Accordingly, it was deemed appropriate to further increase the reserve options coefficients, while delivering a cut in the short-term interest rates.” I fully agree with the central bank on the balanced growth goal. Economic growth exclusively based on domestic demand would unavoidably have an adverse effect on the current account deficit (CAD). The last figures show that the CAD-to-gross domestic product (GDP) ratio, which fell to 6 percent from 10 percent started widening slightly again. So, the desired revival in domestic demand must be kept under control while the supplementary growth must come from net exports. Doing so, exports have to rise more than imports. Now, it is not easy at all to achieve these double goals. Keeping domestic demand under control necessitates a rather tight monetary policy and the pursuit of fiscal discipline. The last cuts in the central bank's interest rates pushed the expected real interest rate in the negative zone; the indicative Treasury Bond rate went down to 5.5 percent while expected inflation remained over 6 percent. I do not think that there is further room for interest cuts. If this happens, credit expansion would be out of control, jeopardizing the credibility of the central bank in its fight against inflation. As for fiscal discipline, it is as solid as a rock according to the latest budget figures; the primary surplus is higher than that of last year in the first quarter. However, the actual macroeconomic framework does not seem to be able to produce growth close to 4 percent, which is targeted in the Medium-term Economic Program (OVP) and constitutes the minimal rate required to prevent unemployment to increase. Let me note that the unemployment rate, at 9.4 percent, is actually 0.4 percentage points over its level of last year. If the growth rate remains weak, admittedly the increase in unemployment will become more apparent and then more threatening for the government as electoral days are approaching. It would be worth noting at this point that the International Monetary Fund (IMF) forecasts only a 3.4 percent growth for the Turkish economy in its latest survey released this week. Balanced and at the same time sufficient economic growth seems quite elusive. The central bank would certainly prefer relatively low growth but sufficiently safe to secure economic and financial stability, while the government prefers robust growth enough to prevent an increase in unemployment. I do not think that the government cares about the source of the growth. This dilemma is capable of creating a serious rift between the central bank and some Justice and Development Party (AK Party) ministers in the coming months. By the way, the split is already quite visible. Mr. Zafer Çağlayan, minister of economy, reacted to the interest rate cuts by saying, “Good, but not enough.”