The not-so-peculiar inflation in Turkey

There are reasons why inflation has decreased despite the central bank's low interest rate policy

Inflation in Turkey, in itself, is hardly important for India and most other countries. However, we have a very interesting and important lesson from there.

The Central Bank of the Republic of Turkey (CBRT) has reduced its interest rate despite the high inflation in Turkey. Most economists have found the policy surprising. The CBRT has reduced interest rates from 24 per cent in mid-2019 to 8.5 per cent at present. What’s even more intriguing for many people is that the inflation rate has not risen further or stayed the same in recent quarters; it has halved! How did this happen?

It is true that low interest rates can encourage spending on capital formation, housing, consumer durables, etc. And, this additional spending can push inflation higher. However, though the CBRT’s own interest rate is very low, it is important to make a qualification here. Interest rates in the market are not actually very low there; this is particularly true in the more recent quarters. The interest rate on consumer loans is around 35 per cent in Turkey, and housing loans are close to 20 per cent. And, given the actual interest rates in the market and the prevalent uncertainty, spending and inflation are unlikely to be very strong. This is one part of the story.

Another part of the story is that at the low interest rate set by the CBRT, the demand for central bank money would be high. However, the CBRT is actually not issuing a large amount of money to meet this demand. The logical conclusion is that the CBRT is, what can only be called, rationing the “limited” money that it issues. And, since the growth rate of base money is kept in check, accordingly the growth of money in circulation with the public is also in check. All this is not contrary to the fact that inflation is not getting out of hand — notwithstanding CBRT’s policy. 

A bit on the rationing of funds. Even in normal times, we have credit rationing worldwide. But that is actually a market phenomenon. At any time, the supply of funds by lenders can be limited relative to demand, and yet the interest rate does not rise to clear the market, and some less creditworthy borrowers and relatively doubtful projects get rationed. However, what is happening in Turkey is rationing that is over and above the usual credit rationing. This new rationing is due to low administered interest rates, and not market-determined interest rates. And, this rationing is primarily carried out by the CBRT rather than the banks and other financial institutions.

This new kind of rationing has been an important improvisation by the CBRT in more recent quarters, though it is likely a case of some trial and error to deal with an evolving situation under pressure from President Recep Tayyip Erdoğan. Though the improvisation is much appreciated, the low interest policy does have its pitfalls.

First, the actual interest rates in the market can, as mentioned earlier, remain relatively high. Second, the allocation of “limited” funds by the central bank can get discretionary and even arbitrary. Third, the low interest rates — to the extent that they are actually low in the market — can push Lira substantially down — more so when there can be momentum and strong self-fulfilling beliefs in the currency market. So, there are indeed some difficulties with the kind of unconventional policy that is in operation in Turkey. The policy package needs to change there. How this change should happen though is another story.

The main point here is that inflation can fall despite a low interest rate policy! The apparent puzzle is resolved once we get away from interest rates and look at money and prices. In Turkey, on the one hand, the rate of growth of broad money has fallen from 86 per cent to 41 per cent. The figure for narrow money fell from 96 per cent to 32 per cent. The figure for base money fell from about 85 per cent to less than 30 per cent. And, on the other hand, the inflation rate has come down from more than 80 per cent in October 2022 to less than 40 per cent at present. We are having a reversal of the phenomenon that “too much money chases too few goods”, and consequently inflation is reduced. 

To conclude, all things considered, politicians do need to listen to economists. However, we economists too need to be flexible in the analytical framework that we use. Otherwise, people will be seriously affected by what Ronald Reagan once quipped, “Economists are people who wonder if what works in reality can also work in theory.”

The writer is visiting professor, Ashoka University. gurbachan.arti@gmail.com. Vanshika Tandon contributed to this column