Inflationary surprises

pandemic a V-shaped recovery AFTER THE was expected – demand would pick up. It indeed did. Furthermore, supply chains were disrupted so there were global supply bottlenecks in 2020 and 2021. Monetary policy was extremely loose because governments were fighting the economic contraction the pandemic caused. Budget deficits soared as direct income support to households reached very high proportions. All these were financed through monetization. These are the main factors that can help explain U.S. or European inflation today: 5-7% annually. However, Turkish inflation has very little to do with that general phenomenon. It is unique in the sense that its causes were and its consequences will be entirely different. Now, the U.S. can conquer its 7% inflation because they know why it happened and what to do to lower it. Here, conquering a run-away inflation won’t be that easy.

WAS THIS INFLATION ENGINEERING OF THE BARRO̞GORDON TYPE?

Why did inflation happen and why did it happen so fast? Inflation engineering of the Barro-Gordon type could provide one answer. Accordingly central banks deliberately cause inflation, i.e. they ‘engineer’ it. However, in Turkey engineering an inflationary surprise so the real value of the public debt stock erodes may not have been a viable option because the FX-denominated component of the domestically issued government debt was already on the rise last year. Yet, everybody knew that cutting interest rates would cause the exchange rate to jump and high inflation to follow. Is there any rationale behind such a dramatic increase over the span of six months that economists can’t understand? Was cutting the policy rate in September 2021 the main culprit? Was that decision a simple error or was there a logic behind it? After all, inflation has officially skyrocketed from c. 20% in September to c. 60% in March. Unofficially, it is bordering on hyperinflation now. Producer prices are up by 115% over the last 12 months. Is inflation uncontrollable? When and where will it peak?

WILLING THAT WHICH CAN’T BE WILLED

Since no small open economy can simultaneously control both the interest rate and the exchange rate, unless it closes itself to cross-border capital movements, willing that which can’t be willed won’t work. One reason for this is obviously the high inflation that will result. As the exchange rate jumps, so does inflation. Also as spending rose after the partial lockdown inflation increased in tandem. When the policy rate was cut in September, and it was already low, inflation quickly headed north, further depressing the already negative real interest rate ex post as if there were an inflationary surprise in the spirit of the classical Barro-Gordon model (1983). This invites all sorts of credibility problems. In short, there were already serious inflationary pressures and a small perturbation could unleash hell. This is exactly what has happened over the last six months. Furthermore, bank capital is shored up by TL injections, and TL credit creation outpaced core funding growth rates. All of these are now stylized facts in Turkey.

EXPORTS

Because corporates are FX-indebted and the import content of exports is very high (60% or more) Lira depreciation doesn’t simply trigger exports. Yes, it does but only with a considerable lag and it does so only if the real exchange rate remains low for a long period. The main channel of Lira depreciation is via imports. A sudden Lira depreciation –nominal exchange rate increase- deters imports and contracts the economy. Or it curtails investments and contracts the economy –or both. A misaligned exchange rate doesn’t equilibrate the sources of growth through reallocation of resources across sectors; it tips the economy off balance.

INTEREST RATES AND EXCHANGE RATES

There is no one-to-one correspondence between the rate of interest and the exchange rate. Still, in a small open economy the rate of interest is often the only variable that can control the exchange rate. Thus, it is possible to defend the currency, both under a peg and under the float, up to a certain threshold beyond which the relationship is reversed. The main example is when the degree of fiscal dominance over monetary policy determines the threshold. This doesn’t apply to Turkey but there are many other situations when non-monotonic relationships lead to regime-switching, whereby the relationship between the exchange rate and the interest rate becomes non-linear. I will stick to the synthesis provided by Lance Taylor some 20 years ago that the exchange rate expectations and the conditioning interest rate – actually the difference between the U.S. and Turkish rates – are the only variables of interest when it comes to equilibrium exchange rate determination. This is generally true but it doesn’t encompass a situation where the rate of interest is artificially kept low. In other words, the Lira would be

under pressure anyway, but not this much and not so early.

IS IT INCOMES POLICY?

In old literature, what has been called incomes policy simply meant that real wages had to be eroded through high inflation because nominal wages were sticky downwards. Indeed, it is rather difficult to imagine a collective or individual bargaining contract whereby nominal wages are cut and labour accepts that because there is recession or crisis etc. Nevertheless, an inflation adjustment that is fixed to say 10% may ex post imply a real wage decline if inflation surpasses 10%. However, this isn’t the end of the story. Even if the inflation target is 100%, labour loses in real terms nonetheless. How so?

A DIFFERENT STORY

The argument can be summarized as follows: (a) Even if you raise the nominal wage by exactly the rate of past year’s inflation (100% backward indexation, as in Latin America in the 1980s) you still don’t protect the real wage fully and (B) real wages erode even with full indexation as the inflation rate increases or as the adjustment period is prolonged. To grasp this intuitively, assume wages are adjusted every 5 years. In this scheme the cumulative inflation is calculated over 5 years, and then wages are raised at this rate at one stroke –but after 5 years of suffering because inflation is continuous, not discrete. Would this do? No. The same logic applies to yearly backward-looking inflation adjustments. In Lance Taylor’s 1983 book’s table, we see that if inflation is 10% and if wage adjustment is made once a year after the fact, the real wage falls by 5% even if the adjustment is full, i.e. 10%. If the real wage index is set at 100 in 2021, and if the adjustment is made yearly at the inflation rate, then the real wage index still falls to 92.5 in 2022. Adjustments ought to be continuous, say, monthly, and they need to be better be adjusted in a forward-looking manner if the aim is to fully protect the real wage. Admittedly, this is a labour union management perspective, not the perspective of an entrepreneur. However, this is why collective bargaining and labour unions exist, and this is why “democracies pay higher wages.”

AN EXAMPLE OF PERVERSE MONETARY POLICY EFFECT

A widely acclaimed conjecture in developmental macroeconomics maintains that a central bank-engineered rise in the real rate of interest will lead to a real currency appreciation and will make government debt attractive. We have indeed seen many instances in Turkey whereby this conjecture proved true. But we have also witnessed that, if real interest rates increase the probability of default, government debt may become less attractive – at the going rates of interest – and currency depreciation may ensue. The latter outcome is more likely the higher the initial debt stock, the higher the proportion of FX-denominated debt, and the higher the price of risk are. If an interest rate spike raises doubts of default, inflation targeting – be it implicit or explicit – under the float and via a Taylor rule is not immune to a perverse effect. Even an interest rate increase in response to higher inflation can lead to real depreciation. Assuming structural change is incomplete, and therefore the pass-through is still high, a real depreciation automatically implies higher inflation. This is exactly what has happened in Turkey since the 1990s.