If some people are obsessed with interest rates and if they hold important offices, it becomes difficult to design economic policy.

You might sure want interest rates to be low regardless of the general economic circumstances.  But this would be nothing but a fantasy. Rather than fantasizing, it is necessary to make sure that conditions which will keep interest rates low are fulfilled. For instance, if the problem is indebtedness, borrowing behavior must be revised. Or if there is a savings gap and the economy needs to borrow from abroad, the economy will inevitably be affected by external developments. If interest rates abroad are rising, they inevitably rise in the borrowing country as well. To overcome this, it is necessary to improve the domestic savings rate and lower economic risks.

If some people are obsessed with interest rates and if they hold important offices, it becomes difficult to design economic policy, in particular monetary policy. In some extreme cases, it might be impossible to make critical decisions. If those decisions cannot be taken in time, risks would grow and interest rate would escalate further beyond the level it would normally reach. This process runs through the market mechanism. In short, obsession about interest rates in the end pushes the rates up, which inflames the obsession. And we get ourselves a vicious circle: if the monetary authority refrains from raising the policy rate due to the low-interest-rate obsession, risk perception of the markets grows and pushes the rate up further. This feeds the obsession, policy rate cannot be increased, risk perception escalates again, and market rate increases further, and so on.

In the next three years Turkey will be facing risks that might push up exchange and interest rates. The main reason for the FX outflows and resulting exchange rate and interest rate hikes in emerging market economies lately was the Federal Reserve’s (FED) initiation of the monetary tightening process in the US. The tightening will be more exhaustive compared to previous examples since the FED has done “abnormal” amounts of printing due to the global crisis. And of course there is Europe. Excluding Southern Cyprus, things seem to be on track in Europe since fall 2012. Yet certain risks remain intact. For instance, the judgment of Germany’s Federal Constitutional Court on the current hearing might derail the European economy. Of course this is just a possibility. The FED story, on the other hand, is not a possibility; it’s happening.

Therefore, Turkey has to adjust itself to the trend of higher market rate and an upward-movement in exchange rate. Of course in certain timeframes both rates might decrease, but the downwards movements will not be permanent. The main trend will be an upward movement. In this picture, the Central Bank is expected to adjust itself to the increase in the market rate and raise its policy rate accordingly. But the Bank had a “bad” experience in 2006 in this respect.

At the end of April 2006, the Bank cut its policy rate from 13.5 to 13.25 percent. The market rate back then was 14.5 percent. Due to international conditions, the market rate and exchange rate started to increase soon after the rate cut. By the end of May, exchange rate was 20 percent higher compared to April and the market rate reached 18.3 percent. The upwards movement continued in June, with exchange rate increasing by 28 percent and market rate hitting to 25 percent. In response, the Central Bank at once increased its policy rate by 4 percentage points and again slightly a month later, finally raising it to 17.5 percent.

Meanwhile, GDP growth decreased from 8.3 percent between 2005 and the first half of 2006 to 4.7 percent in 2007. Of course, other factors too were at work here. But it is not what really happened that matters for our discussion. It is how it was perceived. If there are people around who are willing to have low interest rates regardless of the of the general economic circumstances, i.e. who are obsessed with the interest rate, and if these hold important offices, the perception might become like “the Central Bank has increased interest rates and weakened growth.”

This commentary was published in Radikal daily on 04.07.2013