A Turkish Experiment on the Theory of Interest

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Recently, Turkey’s economic situation has become the headlines of global newspapers. In addition to the fact that its property prices have risen the world’s highest in 2021, it is more important that the central bank of Turkey cut interest rates continuously when the inflation rate was climbing over 20%, resulting in a plummet of the currency exchange rates.

Turkey’s property prices have risen highest in the world

After the outbreak of the pandemic, property prices in many countries have risen sharply, but the growth rate of Turkey’s house price index has outperformed all other countries in 2021. The latest announcement of the housing price in Turkey in October 2021 has achieved an annual growth rate of 40%! Even after deducting inflation, the real house price increases by 16.8%! (Figure 1)

Figure 1 Annual nominal and real residential property price indices of Turkey. Source: Merkez Bank ASI (2021)

Turkey’s inflation rate is rising fast

The growing red shaped area in Figure 1 also indicates that the inflation rate of Turkey is rising fast. In November 2021, its inflation rate rose to 21.31%, and this is the second time in the past four years that the inflation rate exceeded 20% (Figure 2).

Figure 2 Turkey’s inflation rate, 2017–2021. Source: Trading Economics

It is true that inflation has become common in the world after the outbreak of the pandemic, especially when the logistics supply chain is severely disrupted. The inflation rate of the US, for example, is reported to be 6.8% in November 2021 which is the highest since June 1982, yet it is still rare for OECD countries to have inflation rate above 20% in recent years. Why causes the high inflation rate in Turkey?

Raise interest rates to curb inflation

It has become a common knowledge that raising interest rate is a cure to high inflation, as higher cost of capital deters credit demand. It can help increase savings and reduce borrowing, inflation will fall.

In fact, during the Great Inflation period in the United States in the 1970s and 1980s, Paul Volcker, the then chairman of the Federal Reserve Board, has raised the federal funds rate to 20%, and successfully curbed the Great Inflation. This event of raising interest rates to curb inflation is worth reviewing, because the situation is quite similar to the situations today. The following quotations from Amadeo, Kelly & Baker, K. (2021) tell us what caused the Great Inflation and how it was developed into a stagflation:

“Volcker fought greater than 10% annual inflation rates with contractionary monetary policy and courageously raised the fed funds rate to 20% in March 1980. … Volcker knew he must take dramatic and consistent action for everyone to believe he could tame inflation. President Nixon had contributed to inflation by ending the gold standard in 1973. The dollar’s value plummeted on the foreign exchange markets. That made import prices higher, creating inflation . Nixon tried to stop it with wage-price controls in 1971 that restricted business activity, slowed growth, and created stagflation.

Fed Chair Alfred Hayes tried to fight inflation and recession at the same time as he alternately raised and lowered interest rates. His stop-go monetary policy confused consumers and businesses. Worried companies just raised prices to stay ahead of future high interest rates. Consumers kept buying before prices rose even more. The Fed lost credibility, and inflation rose to double digits.

Thanks to Volcker, central bankers realize the importance of managing inflation expectations. As long as people thought prices would keep rising, they had the incentive to spend now. The added demand drove inflation even higher. Consumers stopped spending when they realized Volcker would end inflation . Businesses stopped raising prices for the same reason.” (Amadeo, Kelly & Baker, K., 2021)

The understanding of the relationship between interest rate and inflation rate can be traced back to Irving Fisher’s (1930) Theory of Interest. It points out that it is NOT the nominal interest rate that matters, but it is the difference between nominal interest rate and inflation rate (and risk premium) that matters. In Turkey, for example, the current nominal interest rate (14%) is relatively high in comparison with that of the other OECD countries. However, when the inflation rate is higher than 20%, the real interest rate becomes negative. That is, saving deposits will only make a loss. It discourages people from saving, and urges people to spend, invest or even hoard assets and consumables. Raising interest rate to a level above inflation rate (a positive real interest rate) can therefore help encourage people to save more and borrow less, which can then bring inflation down.

Turkey cuts interest rates to curb inflation — a test of the real interest rate theory

However, the Turkish President and the Central Bank do not believe the Theory of Interest. Instead, they try to cut interest rates to curb high inflation. The one-week repo auction rate has been cut four time (5% in total) since September 2021, from 19% to 14% this week. “The Turkish lira plunged as much as 5.6% to a record low against the dollar on Thursday after the central bank slashed its policy rate in line with an unorthodox economic programme.” (Erkoyun & Devranoglu, 2021)

Figure 3 shows Turkey’s one-week repo auction rate in the past five years. It shows a continuous decrease of the policy interest rate since September 2021, and if it is compared with the inflation rate in Figure 2, the real interest rate has become negative since July this year, and further interest rate cuts have led to a more serious negative real interest rate. The market has formed an expectation of higher inflation, which makes inflation worse.

Figure 3 Turkish interest rates. Source: Trading Economics

The Turkish lira depreciates sharply

It has become a textbook knowledge nowadays that “countries with weak economic fundamentals, such as … high rates of inflation, generally have depreciating currencies.” (Smith, 2021)

In fact, once after the central bank of Turkey announced the resolution of interest rate cut, the exchange rate of USD to TRY (Turkish lira) rises to a record high of 15.689 (Figure 4). When the currency depreciates, people will look for assets to hedge inflation. Among them, real estate in particular is one of the best assets to hedge inflation.

As illustrated in my previous article (Yiu, 2021), inflation rate is overwhelmingly shaped by housing rents, A high inflation rate implies that housing rents have risen substantially. People with money in banks or in cash are therefore keen to buy residential properties. The results of this Turkish experiment support the hypothesis that negative real interest rates cause property prices hikes.

Figure 4 U.S. dollar to Turkish lira, 2017–2021. Source: Trading Economics

The Turkish government conducted an empirical test of the Theory of Interest, using Turkish citizens as experimental objects. It shows the predictive power of the theory.

References:
Amadeo, K., Kelly, RC & Baker, K. (2021) Paul Volcker: The 6'7" Giant Who Ended Stagflation and Has His Own Rule, The Balance, Oct 30. who-is-paul-volcker-3306157

Fisher, I. (1930) The Theory of Interest, as determined by Impatience to Spend Income and Opportunity to Invest it, New York: Macmillan. interest

Erkoyun, E. & Devranoglu, N. (2021) Turkish lira hits new low after Erdogan’s latest rate cu, Reuters, December 17. t

Smith, T. (2021) Currency Depreciation, Investopedia, June 21.

Yiu, C.Y. (2021) Why Hong Kong’s Inflation Rates Can Keep Low?, Medium, December 17.

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