Tuna Yilmaz and Senay Selfoglu

Inflation rose and the economy slowed down in 2021. Inflation rose in both the first and second quarters of 2021 due to base effects. The drop in pandemic-related inflation was offset by disruptions to the supply chain, and the rise in commodity/food prices. Producer and consumer prices continued to climb. The rise in inflation is likely to continue into the first quarter 2022. However, there are possible divergences from monetary policy starting in the second quarter. 

Due to high inflation, several central banks from developing countries increased their interest rates in 2021. While there were some central banks that did not increase rates, the Turkish central banking (CBRT) was the one to reduce interest rates. This is despite Turkey being the country with the highest levels of inflation, interest rate, and risk premia. 

Tensions between CBRT officials and Turkey’s government began in 2013. President Erdoğan has dismissed central bank governors on numerous occasions because he did not find higher interest rates permissible and saw them as an obstacle to investments. 

Financial markets welcomed the appointment of Governor Naci Ağbal in November 2020. Ağbal implemented tight monetary policy and there was a decline in the exchange rate. Although there was an increase in US bond yields during February and March, which placed pressure on assets from developing countries, there wasn’t a negative divergence of the Turkish lira as there is now. Ağbal’s continued interest rate hikes resulted in his dismissal, and caused the markets to lose faith that the central bank was operating independently. 

It is also necessary to mention the period before the current governor, Şahap Kavcıoğlu. Lütfi Elvan, who was appointed finance minister after Berat Albayrak’s resignation was generally accepted by the markets. However, he was also dismissed because he did not support the government’s policy stance. 

The Turkish lira, which had recovered in the November 2020 to March 2021 period, began to weaken as Kavcıoğlu, who supported low interest rates, assumed the central bank governorship. Although the interest rate was kept constant until the September meeting, both Erdoğan’s statements and the markets expectation of interest rate cuts at each meeting weakened the lira. 

We arrived in September to find that inflation had reached the highest point in recent years in most countries, while new strains of the pandemic were causing a reemergence. Problems with global supply chains also affected countries. The CBRT indicated a cut in interest rates during this time, with the focus shifting from core inflation to headline inflation. The lira accelerated losses with Erdoğan stating that “interest rates should be even lower.”

In November, the rise in accelerated as the interest rate cuts took effect and the situation was described as a “war”. Although it wasn’t clear who was behind the fight, there was discussion about a new economic model. Each speech led to further appreciation in the lira because inflation was not the primary objective. 

Is there a plan? Will it tackle inflation?

The Turkish Central Bank will keep the interest rate at zero until the third quarter in 2022. The expected result of investments is a surplus for exports and higher tourism revenue, as well as low interest debts.

It is absurd to say that the plan does not include a strategy for reducing inflation, while the primary goal of the central banking is price stability. It is impossible to believe that the economic plan can be implemented in a sustainable way. 

If President Erdoğan persists with this approach, by the end of the first quarter inflation could be approaching 30%. In the end, it is likely that there will be an increase in interest rate in the future. Will this happen with the current central bank governor?

Although the CBRT is now free from all global risk and has set an inflation target, they may have to raise their interest rates aggressively. But, USD/TRY could continue rising until that time. 

2021 is not over yet but USD/TRY exceeded 18.00 in December and had risen over 100% before Erdoğan’s recent measures. The 2001 economic crisis saw a similar decline, which was due to the negative effect of the political intervention. 

The markets favor fiscal and monetary policies that are consistent with economic fundamentals. But they want independent decision-makers. Turkey can reap the benefits of the right policy if it has the right people and at the right moment. The greatest problem for the economy is not having these conditions.

Turkey is likely to experience high inflation in 2022. A year of runaway inflation in Turkey will reduce the purchasing power and volatility the exchange rate. It is better to abandon the current inflation policy and focus more on it. 

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