SEYFETTIN – Has interest rate fighting ended?

Has interest rate fighting ended?I hope so but I am not so sure. President Recep Tayyip ErdoIan had a critical meeting with Deputy Prime Minister Ali Babacan and Central Bank Governor Erdem BaII on Thursday.

During the two-hour meeting Mr BaII made a presentation of 133 slides to the president of the republic accompanied by his economic aisers. The first 32 slides were designed to explain the basic economic principles governing the relationship between interest rates, exchange rates and inflation in a very pedagogic mannerScreening these slides it is very easy to see a lesson addressing the president of the republic.

The governor is showing how, in an economy with a large current account deficit (CAD) that thus needs capital inflows, a loose monetary policy (too low interest rates compared to inflation expectations) would cause a depreciation of the local currency, which would be followed by an increase in prices of imported goods and thus higher inflation. This is, clearly, what happened in previous weeks.

A comparative table was also presented showing how in emerging countries with a CAD and relatively high inflation, the policy rates of the central banks are higher than the Turkish one. Mr BaII probably informed them that the Brazil Central Bank made its fourth increase of the policy rate a few days ago, setting it at 12.

25 percent. Let me point out that the Turkish policy rate was lowered to 75 percent last month.

The presentation also explains that market interest rates depend on the risk premium, the equilibrium real interest rate and expected inflation. The market interest rate that was lower than 7 percent two months ago is actually well over 8 percent.

That is increased risk premium because of uncertainties caused by the harassment of the central bank.Moreover, Mr BaII discussed the determinants of private investment.

Private investment depends on the level of the real interest rate, which is currently quite low — about 1 percent. Beside the real interest level, the two additional determinants of investments are confidence and stability.

Mr BaII argues that structural reforms will reinforce these critical determinants. In other words, Mr BaII objects to Mr ErdoIanand#39s point of view defending that a sharp cut of the policy rate will lower market interest rates as well as inflation and thus will increase investments that will boost the economy before the general election to be held on June 7In fact, Mr BaII defines three conditions to further reduce the policy interest rate: 1) steps to back confidence and stability 2) fiscal discipline and 3) a monetary policy focused on price stability.

If these conditions are satisfied, inflation expectations as well as risk premiums would decrease and it will be possible to cut the central bank interest rates. There is no problem with fiscal discipline at the moment.

But confidence and a monetary policy focused on price stability depend on an independent central bank getting rid of political pressures.What was the result of the meeting? Letand#39s first see the comment of Mr ErdoIan before presenting my impression.

He said: andldquoWe settled our differences in the end. I hope we can go ahead with this result in the coming days by having more frequent meetings,andrdquo while the official communiquandeacute underlined the presidentand#39s andldquosensitivitiesandrdquo regarding interest rates.

Has Mr ErdoIan been convinced? Compared to his previous diatribes claiming that high interest rates are tantamount to treason and the governor needs to andldquoshape up,andrdquo these declarations signal a change in the attitude of the president, at least. I am not sure if Mr ErdoIan is ready to admit that his thinking on inflation-interest rates interferences is erroneous.

However, I believe he is considering that the turmoil provoked by the interest rate fighting may damage Justice and Development Party (AK Party) support in the general election.So I think he will ease up on the pressures on the central bank until the election.

That said, to be certain we have to wait for the meeting of the Monetary Policy Committee (PPK) on March 17. The majority of economists, myself included, believe that given the recent increase of the exchange rate and market interest rates, the committee has no room for even a very limited interest rate cut.

The interest rate decision at March 17 will reveal, in fact, the kind of understanding that was settled on after the presentation by the governor.

SOURCE: Today’s Zaman