News Column

A risky step from the central bank

July 19, 2014

ISTANBUL (CIHAN)- The Monetary Policy Committee (PPK) decided to decrease its policy rate (one-week repo rate) from 8.75 percent to 8.25 percent and its borrowing rate from 8 percent to 7.50 percent at its meeting on Thursday. The daily marginal funding rate (the upper cost of lending) has been kept at 12 percent.

The PPK did what markets were expecting. We do not know what Prime Minister Recep Tayyip Erdogan thinks about this decision yet. He is probably not very happy, since he clearly wants the central bank's rates at much lower levels. Another harsh criticism directed against central bank management would not be a surprise, but will simply confirm his intention to change both economic policies and management.

Tuesday, I wrote in respect of this critical interest rate decision that, although "Mr. Erdogan is not easing up on the pressure he is putting on central bank managers, I do not think any further room actually remains for an interest rate decrease." I added that if a limited decrease is decided upon, this will be perceived as "a sign of weakness in business circles," and if interest rates are kept unchanged, central bank managers must be ready to face "the fury of Mr. Erdogan once again." Many commentators considered this decision a risky step, and I agree with them, but Mr. Erdogan's reaction might be rather moderate since interest rates have been lowered once again, albeit not enough in order to satisfy the prime minister.

I think that the Turkish Central Bank has taken a risky step indeed. Before going through my objections, let me quote the arguments of the PPK. It says: "Loan growth continues at reasonable levels in response to the stance taken supporting tight monetary policy and macroprudential measures. In line with these developments, recent data point to a modest course in private final domestic demand. Meanwhile, with the help of the recovery in foreign demand, exports contribute positively to economic growth. The committee expects that such a demand composition will support disinflation and will lead to a significant improvement in the current account balance in 2014. The adverse impact of exchange rate developments since mid-2013 on annual inflation is gradually tapering off. Recently, elevated food prices have been the main factor limiting the pace of decline in inflation. In light of these assessments and the recent improvement in global liquidity conditions, the committee decided to deliver a measured cut in the one-week repo rate."

I inserted a long quote to avoid any misinterpretation. The bottom line of the central bank's argumentation is that lower interest rates present no risk of demand pressure on prices in the future, even though real interest rates were near zero. It is true that the calm continues reining in the exchange rate market, in a way comforting the central bank, since no depreciation of the Turkish lira is in sight, all the more since the European Central Bank is pursuing a loose monetary policy. Nonetheless, the consequences of a zero real interest rate might be very costly regarding the fight against inflation. Bank loan interest rates have already been decreased by nearly 200 basis points in the last two months along with the interest cuts of the central bank. The last cut will most probably push banking interest rates down further. We know that interest rate changes affect housing demand and consumer durables with a lag of a few months. Before deciding on a third cut, the committee should have waited two or three months in order to observe the effect of decreasing interest rates on demand. It claims that "loan growth continues at reasonable levels in response to the tight monetary policy stance," but no longer can it be sure that banking loans will not start growing more than it desires in the near future.

Such an event will put the central bank in an inextricable situation, since the current inflation around 9 percent is still far from its target of 5 percent and inflation expectations have increased in recent weeks. It is well-known that it is much more difficult to increase interest rates than it is to cut them, particularly given the heavy political pressure on the central bank. At the end of the day, I think the central bank made a risky decision and, most probably, it will be obliged to increase its policy interest rate in the near future -- if, of course, today's management is still in place.


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Source: Cihan News Agency (Turkey)

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