Today, monetary policy in most economies is based on an explicit inflation target, as aiming for price stability has served both developed and emerging markets well.
Until pandemic-related disruptions to supply chains and labor markets began fueling rapid price growth, inflation was well below target in major economies and, sooner or later, the question of what to do in such situations will return.
The 20th century American economist Irving Fisher had an answer. Economic orthodoxy dictates that central bankers raise nominal interest rates when inflation exceeds policymakers’ target. After all, rising interest rates reduce borrowing and spending, cool the economy, and dampen inflation.
Fisher, however, argued that when inflation is too low, central banks should raise their nominal interest rate targets. He argued that there is a positive correlation between nominal interest rates and inflation. This relationship, known as the Fisher effect, is visible in economic data. Modern macroeconomists interpret causality as running from inflation to nominal interest rates.
Turkey is the first country to put Fisher’s theory to the test – but with a crucial twist. Turkish officials believe that high interest rates cause inflation, so they claim there is a causal link in the other direction. Lower interest rates, according to the Turkish authorities, should reduce inflation. After all, as Fisher argued, the nominal interest rate is the sum of the real interest rate and future inflation. If the real interest rate is constant, the only long-term effect of the reduction in the nominal interest rate will be a reduction in inflation, since any effect on the real interest rate resulting from the reduction in the nominal interest rate nominal interest will disappear in the long run.
But in the short term, this monetary neutrality is absent, so a fall in the nominal interest rate also reduces the real interest rate. And it hurts both domestic and foreign savers, which is a major problem for a country like Turkey, which has a persistent current account deficit to finance its economic growth.
With a currently negative real interest rate, the neo-fisherian experience will aggravate Turkey’s inflation problem. A country that needs both domestic and foreign savings to finance rapid growth cannot offer those savers negative returns.
To encourage further domestic savings, the government recently announced a new policy: if the decline of the pound against major currencies exceeds short-term bank interest rates, the government will pay the difference to holders of lira deposits. For example, if banks pay 15% on lira deposits at 12 months and the lira depreciates by 20% during this period, the Treasury will return the depositors whole.
While this policy may protect domestic savers and prevent them from abandoning the pound, it does nothing to encourage foreign savers. The resulting outflow of foreign capital will accelerate the depreciation of the pound and further fuel inflation. And, because the policy places all of the currency risk on the government, it will weaken public finances and could eventually lead to debt monetization.
Why would the government put in place a more costly alternative to a more restrictive monetary policy? The answer is simple: Turkey’s short-term growth model relies on credit, which requires domestic borrowers to be able to borrow at low interest rates.
But the role of foreign capital flows in these domestic lending rates betrays the model’s fatal flaw. If a country has external financing needs and finances its growth with foreign savings, capital flows are a more important determinant of short-term domestic lending rates than the monetary policy rate – a phenomenon known as of “disconnection of short rates”. Indeed, national banks depend on international financial markets for financing.
For foreigners lending to these banks, there should be no difference between lira deposit rates and dollar deposit rates once adjusted for expected depreciation. This is not true in the Turkish case.
If foreign institutions lend in lira, they charge a risk premium, which has now increased, due to the massive depreciation of the exchange rate. And if they lend in dollars, they charge a premium for the risk of default, which has also increased. The recent record spreads on Turkish credit default swaps are a good example. As foreign investors abandon Turkish markets – or charge higher risk premiums to stay – currency depreciation and inflation will rise.
To defend the lira and revive capital inflows, inflation targeting must be done well. If inflation exceeds the official target, policy rates should be increased to cool the economy and stabilize prices. A small open economy that finances its growth with foreign savings cannot fight inflation and stem currency depreciation without a credible monetary policy. A neo-fisherian approach is no substitute.
Sebnem Kalemli-Özcan, former Senior Policy Advisor at the International Monetary Fund, is Professor of Economics at the University of Maryland, College Park.© Project Syndicate 2022www.project-syndicate.org