News Column

How to interpret the interest rate decrease

June 28, 2014

ISTANBUL (CIHAN)- The Central Bank of Turkey cut its policy interest rate (one-week repo rate) by 75 basis points from 9.50 percent to 8.75 percent. It kept its overnight lending rate at 12 percent and its overnight borrowing rate at 8 percent. The decision made by the Monetary Policy Committee (PPK) on June 24 was all the more anxiously expected by markets, especially since recent political pressure exerted on the central bank by the prime minister and his inner circle for a sizable interest rate reduction made the decision far from one based solely on analytical considerations. Indeed, the credibility of the central bank was at stake; a sizable decrease, say more than 100 basis points, would have been interpreted by the markets as a political decision likely to undermine economic stability.

The dilemma the central bank has been facing was well summarized by William Jackson, an economist at Capital Economics in London, in a note to clients. Jackson said: "The [central bank] is trying to balance the need to maintain credibility in the markets on the one hand and government pressure to lower interest rates substantially on the other. …The larger the size of the easing cycle, the greater the risk that the [bank] will damage its own credibility and the more vulnerable the economy will become to a shock that causes investors to pull back."

Finally, the central bank decided to proceed with a moderate cut of 75 basis points while a large majority of experts were expecting one of 50 basis points. For example, out of 20 economists in a Reuters poll, 16 predicted a cut in the one-week repo rate of 50 basis points, three predicted a 75 basis point cut and one a 25 point cut. Personally, I was expecting -- and at the same time defending -- a cut of 75 basis points. In my June 13 column discussing the first quarter growth rate (4.3 percent), I wrote: "No doubt, the growth performance in the first quarter has reduced the political pressure exerted on the central bank. This will allow the central bank's [PPK] to limit its expected interest rate decrease at its next meeting on June 24. On the other hand, the recent monetary loosening measures taken by the European Central Bank gave the Central Bank of Turkey additional room for an interest rate decrease without provoking an exchange rate shock. Thus, we may expect a relatively sizable but not adventurous reduction in the policy rate, actually at 9.5 percent. Personally, I would agree with a drop of 0.75 percentage points."

The central bank in its note, published after the interest rate decision, defended the cut with similar arguments, saying that inflation was expected to start falling significantly from this month and that global liquidity conditions had recently improved. Furthermore, it underlined the fact that balanced growth (positive contribution of net exports with a moderately increasing domestic demand) is continuing at around 4 percent, lowering the current account deficit (CAD) slowly. Needless to say, that this is exactly the opinion of Deputy Prime Minister Ali Babacan and Finance Minister Mehmet Simsek.

Did this limited interest rate cut satisfy the prime minister? For sure it did not, but he did not react publicly. He has other fish to fry nowadays. However, Economy Minister Nihat ZeybekÇi, a fervent supporter of low interest rates, said after the PPK meeting: "This decision is far from the expectations of the real sector, but close to market expectations. …For a Turkish lira at its real value, high interest rates are not suitable; this encourages imports and creates obstacles for exports."

The real value of the Turkish lira is an endless debate. The fact is that the interest rate cut did not have a rising effect on the exchange rate. USD-TL parity continues at just over 2.10. According to the criteria set by the central bank, the real exchange rate index (2003=100) starts signaling overvaluation as it reaches 120. The index level is around 110, actually. So, there is still some ways to go and, in the meantime, there will be no pressure on inflation coming from the nominal exchange rate increase, which is good news for the central bank.

Nevertheless, the lobby for low interest rates insists on the further depreciation of the Turkish lira; inflation is not a priority for them. Furthermore, they believe that low nominal interest rates (negative real interest rates) would be a good stimulus for domestic demand without paying any price regarding inflation expectations, thus long-term interest rates. They are greatly mistaken.


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Source: Cihan News Agency (Turkey)

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