Inflation as indicator of a structural malaise
Inflation is an index. What it really measures was debated in England about a decade ago. Was it a sufficient statistic conveying the erosion of household purchasing power in toto or was it true that many subgroups had so many different inflations according to how they spend their incomes on different classes of goods and services? Was inflation 3 percent indeed as claimed or was it in fact 5 percent for the majority of the population because necessary goods had posted higher inflation compared to luxuries? It was an ‘index number tournament’.
In Turkey, the situation is different. The reason is twofold: first, inflation was very high for more than three decades, so there is still an illusion left in the back of people’s mind. People aren’t that sensitive to inflation unless it is too high. After all, it is no longer 60-70 percent as before. And who cares if it hovers around 7 percent or 9 percent? So, enter the second reason: whether the CPI print is 8 percent or 10 percent doesn’t make much of a difference for households because people on the street don’t exactly feel the difference. From 2 percent to 5 percent there is a huge difference and it can be felt, but from 7 percent to 9 percent no way! There is also the always extant ‘gut feeling’ that “real inflation” might be somewhere higher. Hence, people have developed a popular yardstick: the exchange rate. The USD/TRY rate serves as a barometer not only for corporates or for investors but also for the man on the street even though he might not actually be holding any dollars. The insensitivity to fluctuations at the margin of the CPI could be labelled ‘money illusion’ because what matters is the ability to consume. For long-term commitments, such as mortgages, of course the situation is different but not for day-to-day expenses. Give them the money and they will spend whether inflation is 8 percent or 10 percent regardless. Neither do they vote according to the rise and fall in inflation. Current disposable income and the exchange rate are the keys to deciphering the mechanism through which ‘economic voting ’ works.
Hence, inflation has become a variable that resident and non-resident investors use in order to get an idea of what a temporary “equilibrium real interest rate” should be. Obviously, inflation matters here. The level and the volatility of the exchange rate are the prime movers but, in the end, they amount to the same thing: both the exchange rate and the import prices passthrough inflation because the pass-through coefficient is still very high and it may have possibly increased lately. I would pen in 15 percent pass-through at the very least. That means an additional 2.5-3 percent inflation increase. How does it bear on both the nominal and the real interest rates we have just witnessed? High inflation means high interest rate and no matter how imaginative or unorthodox a monetary policy can be, the end result will be the same. Furthermore, high inflation – inflation will peak at 1415 percent this year barring any further shocks - implies a higher real interest rate. Conversely, if trust can be maintained, higher nominal rates could help reduce the real rate eventually. This is what we will test in the coming months. Because Turkish inflation is cost-push, there is a large spread between producer and consumer prices. Producer prices can be translated to consumer prices because there is imperfect competition and consumption is almost always incentivized, especially ahead of elections. Inflation is widespread across sectors, goods and services and it is quite sticky now.
It is obvious that the exchange rate pass-through is at its peak as regards producers’ prices. Food and transportation prices spiked in the latest print, but this is also related to the exchange rate movement. Unless the lira gains value and the tax component of prices is adjusted downwards – a subsidy - I don’t expect inflation to fall drastically in H2 2018 either. The pass-through is both higher than yesteryear’s coefficient and it is instantaneous – for producers’ prices. The June print is also likely to be high. The producers’ prices graphic shows that such prices go up hand-inhand with the exchange rate and reached the peak level of the last 15 years. Furthermore, oil price hikes have not been fully reflected on consumer prices. The question is: at what speed inflation can fall after its peak level of 14-15 percent over the remainder of the year? This will bear on the equilibrium exchange rate. One way is to wait and see, in which case prices will automatically adjust, demand will fall, and asset prices may slide down echoing unpleasant expectations. The MSCI-Turkey spread already depicts such a
movement – since mid-April. It is still possible to maintain a growth rate of 4.7-5.2 percent on account of the first and second quarters expected high growth rates, but H2 will look completely different than H1. Inflation has become a key variable for asset pricing also.
What to do after the elections no matter who wins? There have been three serious programs in the last 60 years or so. The switch to import substitution and indicative planning in the early 1960s was one. Big names such as Kaldor and Tinbergen came here as consultants at that time although it isn’t clear to what extent their advice was implemented. Planning had a positive effect though. 1965 was the first peak year when GDP per capita rose significantly, but momentum was immediately lost. A momentum of the same magnitude was observed around 1973 due to sharply rising workers’ remittances. 197377 was an interesting period: the consequences of the oil shock were not translated into domestic prices, and the Cyprus Operation took place. The U.S. embargo took off in 1975. 1977-80 witnessed the slippery slope toward the economic decisions of January 24, 1980 and the coup d’état. The economy dived down and rebounded after Ozal. This momentum ended in 1989, and the capital account was opened up. The second through, though not as deep as 1980, occurred in 2001. As the AKP decided to implement the Derviş-IMF program in 2003, the economy jump-started in a way reminiscent of Ozal’s heyday. The AKP momentum died off in 2006. The third through entered after Lehman. The amplitude was not as large as the previous two crises, but it was every bit as real. After 2008, per capita income flattened.
Hence: (1) The 1965 momentum was due to import substitution and the first Five Year Indicative Plan but did not last long enough; (2) Switching from import substitution to outward looking policy was debated in 1971, but no decision came out. Instead, in lieu of exports, workers’ remittances entered the picture in 1972. The 1973 momentum was “manna from heaven”; (3) 1980: the beginning of Özal reforms. The whole world outlook changed, and so did the economic spirit. The impetus lasted 9 years; (4) 2001: the end of another era. Derviş stepped in and opened up 5 years of momentum; (5) 2008: the end of the Derviş program. The Turkish economy had already lost stream before Lehman; (6) no new program, no renewed momentum. Per capita income stagnated; (7) The new GDP series changed the picture, but it posed new questions and created more puzzles than it solved.
On the other hand, if we look at the world per capita series depicted in the graph, we would observe that they are barely concomitant with the Turkish cycles. Even the adverse impact of the 1973 First Oil Shock could have been postponed here due to remittances, and it did only translate into inflation and other economic calamities after 1977. World cycles, at least in the past when the economy was still a closed economy, played a role only as constraints perhaps, and their consequences were felt with considerable leads and lags.
Now, the January 24, 1980 program could have been implemented earlier but politico-economic alliances weren’t ripe, and the switch from import substitution to export-oriented policies was delayed for at least three years, possibly more due to workers’ remittances that flew in in lieu of exports. A similar story can be told for the 2001 Derviş-IMF program. Everybody knew that there was a pressing need for structural adjustment, but it was implemented after the fact, i.e. after the economy was hit by the biggest shock ever in 2001. It seems like there is a habit of dragging one’s feet and doing what is necessary only after a crisis effectively occurs.
Nevertheless, once implemented any new macroeconomic orientation not only slowly feeds into fundamentals but also starts a new cycle by providing unknown stimuli. The first years of the new strategy are always a success. It was a success after the 1950 elections because agricultural (export) prices were very high in the early 1950s, and because USD flows were secured through the Marshall Plan. It didn’t last into the late 1950s, and balance of payments deteriorated, ending in the 1958 devaluation. The first indicative fiveyear plan of the early 1960s was also initially a success. This episode also ended badly, and the 1980 program leveled the playing field once more. This time around the new neo-liberal vision was dubbed outward-looking policy and export-oriented strategy. Turkey’s strategy of reorienting its economy towards exportled growth resulted in a substantial increase in the value and volume of exports during the 1980s. Increased exports of manufactured products constituted the major source of growth in goods exported. Increased revenues from tourism and other services generating foreign exchange also contributed to an improved current account. Hence, it worked initially until such time as, under the pressure of political competition, public spending skyrocketed, and the capital account was opened up in 1989 earlier than it should have been. Hence, it was hoped that foreign investors would buy Turkish domestic debt. The roller-coaster type of zigzagging in the 1990s resulted in high and chronic inflation, a fragile currency, and very high real interest rates. The failure of the Tablita of 2000-2001 warranted another program, and the DervişIMF joint effort came to the rescue in 2001. Again, this program also worked. The first phase was a clear success, until 2006-2007. The trajectory of household debt portrays one facet of the post-2001 cycle: the credit boom of 2004-2005 and the accompanying enormous increase in household debt. Indeed, it is becoming increasingly costly and difficult to keep consumer demand going, despite the fact that in Turkey people do tend to consume always. A new sea-changing program is now warranted once more.