The expectation that the FED will aggressively increase interest rates before the anticipated timeframe dampened the risk appetite towards Turkey and countries alike.

Figure 1. Policy rate (CBT) and benchmark bond rate (GDS): 1 January 2004 – 21 December 2004 (compound, %). Sources: CBRT and BIST

In the previous piece, I raised a number of questions about the possible changes in the Federal Reserve’s (FED) policy. The first one was: “Should a possible interest raise and liquidity withdrawal by FED scare us?” I said this would obviously affect Turkey adversely but we had to take a look at “then” to decide the magnitude of the damage. Yesterday here refers to the spring of 2004.

Here are the figures on the US economy then: unemployment rate decreased from 4 percent in 2000 to 2.7 in 2001 and jumped to 5.8 percent in 2002 and further to 6 percent in 2003. The FED cut interest rates constantly from 6 percent in 2000 year-end to 1 percent in mid-2003. The rate was kept at this level until the end of June 2004. Upon the expectation that that unemployment rate will start decreasing – which in fact did decrease to 5.5 percent and later to 5.1 percent in 2005 – the FED started raising interest rates in July 2004. The rate, by 0.25 percentage-point increases, reached 2.25 percent by the end of the year.

In the spring of 2004 before the interest raises, the expectation that the FED will aggressively increase interest rates before the anticipated timeframe become widespread in the context of the changes in unemployment rate. This expectation dampened the risk appetite towards Turkey and countries alike.

9-points hike in interest rate

Turkey’s credit riskiness, market interest rate and exchange rate increased. Interest rate movements are depicted in Figure 1. The step-like black curve represents the Central Bank’s (CBT) policy rate. The floating red curve shows the interest on the most traded Treasury bonds, that is, the benchmark bond rate.

Policy rate, 26 percent at the beginning of the year, was cut twice down to 22 percent in March and was kept constant until 8 September. However, due the abovementioned expectation, benchmark bond rate (the market rate) moved up starting in May:  24 percent in mid-March to 33 percent in 11 May 2004. The rate floated around 28 percent until August.

The rate hence increased by 9 percentage points. Exchange rate also demonstrated a similar upwards trend: the lira value of Euro-Dollar basket increased from 1.47 in March to 1.71 in May with a total increased by 16 percent in two months. It floated around 1.65 liras between June and November, indicating an increase by 12 percent since March. I am aware of the figure inflation, but I had to use them so as to give an idea about the general picture in 2004. I will continue.

This commentary was published in Radikal daily on 04.06.2013