Since February, both the political and the economic agenda are momentarily dominated by the discussions regarding the interest rate decision of the Central Bank of the Republic of Turkey (CBRT). It was on the 18th February that the CBRT had decided to hike interest rates from 4.5% to 10%. The decision was conceived so radical by the public that the turmoil it created within the politics gave birth to a new rivalry against ex-prime Minister and recently elected president Erdogan as independence of the CBRT has come under scrutiny by the government. On the day when the interest rate was brought down by 50 base points Erdogan criticised the bank’s rate decision by saying “the CBRT increases interest rates by 5 % but decreases by 0.5 %”. This statement was made despite the persistent reminders of the independence of the central bank by the Minister of Economy, Ali Babacan and Minister of Finance, Mehmet Simsek who have strong credibility in both domestic and international financial markets.
Putting even further pressure on the CBRT, Erdogan shared his views once more: “I do not accept the policies of the CBRT as a prime minister. The bank is independent and thus we do not have the right to interfere. However I do not accept their decision. For example; look at the interest rate policy in the USA; 1 %. Japan’s interest rate is negative. Israel’s interest rate is around 1. Then why the CBRT set interest rate around 8 or 9. Adding commission costs, this increases to 15 – 16 levels. This is injustice”.
CBRT bases its interest rate decision on the need to manage the course of inflation, since one of its main duties is to keep inflation low in the country. However, CBRT responded to Erdogan’s persistent pressure by cutting down the interest rates moderately, without having seen clear signs of a decline in inflation. The interest rate in Turkey has now come down to 8.25 % from 10%. It is difficult to tell if such decisions are rooted in President Erdogan’s own theory; “Let me tell you my own theory. I think inflation and interest rates are not inversely correlated but directly correlated. In other words, interest rate is a cause and inflation is its effect. Inflation increases as interest rates increase. If you decrease interest rates, inflation will go down. Thinking it otherwise will always yield worse results.” Economic textbooks teach quite the opposite of what Erdogan claims. Yet, it seems cutting interest rates did not move inflation down so far.
In what follows we will investigate the relation between inflation and interest rates. In doing so, we will first need to define the basic functions of a central bank and where these functions originate. It is clear to everyone that the main duties of central banks are directly related to money. On the other hand we know that none of the economic institutions are exempt from political influence. In this sense; those who had the chance to live before 1980s will rightfully inquire about the relevant importance of central bank in the economy. In order to elucidate the historical mystifications on central banks we will give a brief historical account of why central banks became the locus of the economy from a critical perspective.
[tabby title=”Functions of the Central Bank”]
The legitimacy of central banks has two sources: either money it issues as a means of payment needs to be accepted by society and/or the use of money issued by central bank can be enforced by the state. However, such acceptance cannot only be forced upon the agents but is achieved by ensuring the stability and profitability in the economy. For example, in order to exchange goods against money by the mass of the people in a country, there needs to be enough amount of money for everyone. However, no one can know how much money is needed at a particular time. Sometimes it is required more and other times less. We, as consumers, withdraw more money from banks when we consume more and we deposit it at banks when we have more money than we need. In this case, central banks, as the issuer of money, take in excess money or provide more money when it is needed for economic transactions. In this way, central banks prevent shortage of money or prevent abundance of money at banks. Having such a relation with commercial banks, central banks are lender of last resorts and oblige the duty to maintain the stability in the economy.
Central Banks are also entrusted with the accumulation of dominant or reserve currency of the world (henceforth world money) in order to grant access for local businessmen to international trade, in this case if local businesses choose to enter and compete in the world market. World money (Unites States Dollars) serves as the universal means of payment and its dominant function is to settle international balances. For example if a company want to buy goods from another country, it will not be able to buy with its own unit of money (Turkish Lira, for instance) but it needs USD because USD is accepted as valid in international trade. Central Banks are important for the stable supply of world money (USD) in their own country.
The issue arising now is that what happens if a country needs more world money (USD) than its own local money. This happens when countries import more than they export. Because they purchase more in world money than they can sell in world money. The difference between these two result in a balance of payment deficit.
A balance of payment deficit may lead to a relative decrease in the value of the local currency and an increase in the demand for world money from the central bank. In such situations, central banks may find themselves in drain of world money they own as opposed to a glut of locally issued money. This would melt down the reserves and put both domestic and international functions of central banks at risk. To defend their reserves or attract more of world money and ensure the sustainability of domestic credit system, central monetary authorities may restrain the access of its reserve of international means of payment, raise the price of its own reserves or borrow abroad from other central banks or financial institutions. For example, a central bank may increase interest rates when local banks want to borrow in world money (USD) or stop lending directly. A more drastic way to defend its reserves is to suspend the convertibility of its local money into world money.
[otw_shortcode_content_toggle title=”New Duties for Central Banks: Some History ” opened=”closed”]
Before 1971 the international financial system was anchored to gold. Local currencies were meant to be valued against the gold. However, the valuation structure of local currencies against each other was based on the USD. This is because by the end of World War II, the US had controlled 70 per cent of the total gold in the world and more than 40 per cent of world industrial output. Therefore the value of gold was fixed to the value of USD and central banks accumulated USD with the expectations to exchange their USD against gold. However, the then-unthinkable happened and Central Bank of the United States, the Federal Reserve System (FED), chose to defend its declining gold reserves by suspending the convertibility of USD into gold. This had changed the global financial system fundamentally.
The breakup of gold and USD convertibility transformed the fluctuations in USD, the US balance of payments and the interest rates of US Treasury bonds from being merely an issue of domestic economy to become the anchor for global capital movements. The confidence in the dollar became much more important for the global capitalism. During the 1970s, however, the confidence on the dollar was shattered with the inflationary threat. Economies of both developed and developing countries suffered from high inflation and volatilities in the interest rates and exchange rates. All of these indicated a mismanagement of money as a unit of account. The loss of confidence in the money as a unit of account, especially in the US, along with the loss of the value of the money due to high inflation encouraged the US to defend the credibility of the dollar in the world market, control inflation, and maintain price and exchange rate stability with high interest rates in the late 1970s and early 1980s.
FED’s change of policy in the late 1970s was more of a change in procedures. Instead of targeting an interest rate and trying to reach it with open market operations as earlier, the FED targeted the money supply by forcing banks to bid against each other for the funds they need to keep with the FED. What was intended and aimed indeed was austerity and it was much more important than the change in procedures. The FED, soon after increasing interest rates, realised that it could not control the money supply with the range and diversity of liquid financial instruments that provide money supply into the financial system. It also discovered that all these financial assets that feed the financial system with more and more money were benchmarked and extremely sensitive to the interest rates that itself determined (Federal Funds Rate). Since the FED’s rate became the foundation of calculation of risk, FED became the centre of global finance.
It is not a coincidence that the theory on central banking in response to malfunctioning of money as a unit of account came up with two policy alternatives: central bank independence and inflation targeting. These policies will change the whole economic policy management later on both in developed economies and developing countries including Turkey. The rationale behind these policies, which you will find below, will sound familiar from the tension between the CBRT and PM Erdogan on the interest rates.
The independence of central banks was deemed necessary as the mismanagement of the money as a unit of accounts was believed to originate in the preferences of policy-makers. In the case where the budget is exhausted in expanding production and employment, for instance, policy makers may opt to stimulate inflation and give an artificial boost to output and favour the electorate. Therefore, a central bank that is independent from daily pragmatism of unreliable politicians could maintain the price stability and gain credibility of the money.
Inflation targeting, on the other hand, was thought of as a policy in order to manage the expectations of inflation among business owners and workers; and the GDP growth. If central bank manipulates nominal interest rates with an aim for a targeted inflation, it would then influence the inflation expectations and therefore aggregate demand. In this way, the central bank would maintain the price stability and measuring function of money.
Developing countries meanwhile were required to make substantive changes to their legislative framework in compliance with the International Monetary Fund (IMF). Because the debt crisis and the dependence of developing countries’ on international trade leveraged the IMF to impose conditions for the utilization of loans.
One of the main and iconic changes was the independence of central banks. Even though this was seen as a threat to the interest of elected governments and a source of domestic pressures, the aim was to establish institutionally monetary credibility.
The independence of central banks provided autonomy from domestic pressures in monetary policy but, at the same time, attached its decision making determinants onto stabilising global financial markets and capital flows in coordination with other central banks. The FED assumed the role of world’s central bank and the other central banks were positioned around the FED responding to its policies and procedures.
Institutionally this was achieved by reinforcing and/or strengthening the powers of central banks inside each state for managing the national debt, foreign currencies and money supply. These two state apparatuses now; central banks and ministry of treasury, became the central figures for financial management of countries and the benchmark institutions to the international financial institutions, and both domestic and international financial markets. This meant that demands from other ministries such as labour and industry needs to be tuned to the exigencies of fiscal and monetary discipline. [/otw_shortcode_content_toggle]
 World money is the specific currency that is accepted by the world for international transactions. The most widely accepted currency today is United States Dollar (USD). EUR and Chinese Yuan is following USD.
[tabby title=”Central Banks, Monetary Policy and Inflation”]
The central operations of central banks are founded upon monetary policy. Monetary policy can be simply described as the terrain in which the total money supply is manipulated in order to influence outcomes like economic growth, inflation, exchange rates and unemployment. A number of tools are used to manipulate money supply in line with monetary policy:
- Interest rates, that is, the price at which money can be borrowed. Interest rates are decided by monetary policy committees in central banks monthly in almost all countries
- Reserve requirements; reserve requirement entails the amount of money that is required to be deposited at central bank by banks.
- Open market operations; lastly, open market operations entails the buying and selling of various financial instruments, such as treasury bonds, company bonds, or foreign currencies.
- A hybrid form of these tools is repo funding. Repo is the shorter version of “repurchase agreement” and it is the lending cash money against collateral of treasury bonds and exchanging them back after a certain period of time. In this sense, money is loaned at an interest rate determined by central banks while withdrawing financial instruments from the markets. All of these tools result in more or less an inflow or outflow of money from circulation.
A monetary policy is referred to as contradictory if it reduces the size of the money supply more than required for the circulation. Central banks may increase the interest rates; halt regular repo funding, providing money supply to the financial system through open market operations or increasing reserve requirement in order to withdraw funds from banks. In contrast, an expansionary policy increases the size of the money supply more rapidly by doing exactly the opposite operations.
An inflow of money into the circulation would automatically increase the available money supply in the financial system. Similarly, an outflow of money would limit or reduce the available money supply.
Central banks’ decisions on the money supply through the utilization of monetary policy tools have a direct impact on the interest rates that banks offers to its business customers or individual customers. Under normal conditions where banks do not suffer any financial distress, an additional money supply in the financial system would automatically lower the interest rate that is offered by banks. In this case, customers can access more money and increase their consumption or investments. The result is that consumers have more money to spend, demand for goods outpace the supply, leading to an increase in prices and therefore in inflation. It will also generate more economic activity that will boost the economic growth.
Contrary to popular belief, however, excessive economic growth is not necessarily better but in fact can be very detrimental. An economy that is growing too fast can experience hyperinflation, a phenomena that Turkey suffered for so long during the 1990s. Inflation depreciates the value of local money and risks the fundamental functions of money. At a certain point, the value of the local money means nothing for consumers, producers and savers; they start using world money (USD) in their daily economic activity. This phenomenon was experienced in Turkey during the 1990s and referred as dollarisation. Further, as the value of local money is worth less the earnings of consumers would not be enough against the rising prices.
In a similar logic, an outflow of money from the circulation would increase the interest rates that banks offer and would automatically increase the cost of borrowing. Since it will be more expensive for consumers to get loans from banks, a shortage of money in the circulation will discourage consumers to spend. When the demand for goods does not meet the supply, producers and retailers decrease the prices in order to be able to sell. In this case, the rise of inflation would be halted but this means the economy is at risk for the freeze or minimizing economic activity, which is called stagnation.
Hence the right level of economic growth, and thus inflation, is somewhere in the middle. Interest rates directly affect the market and central banks aim to achieve the right balance by manipulating the money supply in the financial system primarily through changing interest rates.
[tabby title=”What do all these mean for Turkey?”]
Turkey is recurrently having a gap between its money inflows and outflows of its financial system. This means that Turkey needs to finance this gap from foreign financial sources at the interest rates determined globally. If the CBRT keep its rate more than other countries, it will automatically attract more funds. However, interest rates are not the only determinant for investment. International investors seek also fundamental policies in place which are principal conditions for economic stability, such as central bank independency and inflation targeting.
On the other hand, data reveals that Erdogan’s theory on the relation between interest rates and inflation does not hold so far. Remember, Erdogan claims that that inflation and interest rates are proportional. This means that they both decrease and increase together. But data reveals quite the opposite in accordance with economics text books, because interest rates decreased from 10 % in February to 8.25% in July when inflation increased from 7.89 % in February to 9.66 % in July. It seems that the course of the inflation and interest rates will still occupy a fair share of the agenda in Turkish politics.