FX rate transitivity may push inflation up
Between 2005 and 2013, the foreign exchange rate fluctuated but did not appreciate significantly. The fluctuations were noteworthy, bouncing between TRY 1.50 and TRY 2.20 before hitting TRY 2.06 in May 2013 and beginning the downward spiral.
The taper tantrum, which began when former Fed Chairman Bernanke announced plans to slow down monetary easing in May 2013, launched the lira’s depreciation. Last week, it hit TRY 4.68, a 127 percent increase in the currency basket in six years. In other words, the lira depreciated by 55 percent.
Excluding short periods of appreciation, the lira has experienced a 6-year period of depreciation. This cumulative process is expected to have a much stronger influence on inflation compared to mere volatility. The Central Bank’s assumption of 10 percent devaluation leading to a 1.5 percent inflation increase (15 percent transitivity) is not accurate. Considering that the base inflation is at 6.5 percent (the same as May 2013), the transitivity ratio in inflation is increasing each year.
For example, in 2014, when foreign exchange rates increased by an average 5 percent, the inflation trend remained above 1.7 percent. But in 2017, when foreign exchange rates increased by an average 22 percent, the inflation trend was above 5.4 percent. So the transitivity ratio was 11.3 percent in the first year but increased to 25 percent last year.
What does this all mean? I believe the Central Bank should take the fight against inflation much more seriously.
As of today, the average annual increase in the basket is around 19 percent. Even if the exchange rate does not increase from now on, the average exchange rate increase will be 17 percent this year. However, in order to prevent an exchange rate increase, monetary policy needs to be tightened more. But the Central Bank does not appear to be in an aggressive mood. Last week, the benchmark bond interest climbed to 15.75 percent while the funding rate remained at 13.50 percent.
With the assumption that foreign exchange rate transitivity will remain at the same level, we can say that the base inflation rate will be 10.75 percent this year (and that is also compatible with market expectations). But this will climb further in the likely event that foreign rate increases continue. With a rough calculation, an increase of 10 percent in the foreign exchange rate will result in an inflation rate of 12.5 percent. Under these circumstances fiscal policies must remain tight.
The snap election decision led to the expectation that no electoral policies would be pursued. But this expectation didn’t last long: the government announced a retiree bonus package worth TRY 24 billion.
Since August last year, the Treasury raised its debt rollover ratio to more than 100 percent and borrowed about TRY 20 billion more than its normal needs. As of this week, we see that this money has also been spent. The Treasury will have to raise its borrowing again in the coming period, at a time when borrowing rates have reached their highest levels in the last nine years!