Markets take RTE to school

Markets take RTE to school

Governor Erdem Başçı and economy tsar Ali Babacan paid a visit to President Recep Tayyip Erdoğan and his top economic advisers on March 11 to discuss the supposedly-independent Central Bank’s monetary policy.

Başçı’s 130-page presentation could have been titled “Economics for Dummies.” Other than summarizing recent economic developments, the Governor also explained, using examples from many countries, that interest rates do not cause inflation, as Erdoğan claims. On the contrary, inflation and inflation expectations are the most important determinants of market interest rates.

According to Başçı, the monetary policy stance, in turn, is one of the key determinants of inflation expectations. He is probably not surprised that end-year, 12-month ahead and 24-month ahead inflation expectations all rose in the Bank’s latest expectations survey, which was released on Mar. 13.

In his presentation, Başçı gave Erdoğan the key to lowering market rates: Steps to enhance stability and confidence (“do not attack us anymore”), fiscal discipline and a monetary policy stance focused on price stability (“let us do our job”). Since inflation expectations and the inflation risk premium would fall as a result, market interest rates would fall gradually.

He didn’t go as far as to state that they were binding constraints, as I have been arguing, but Başçı also addressed Erdoğan’s growth worries by highlighting stability and confidence as the main determinants of investment other than interest rates. He argued that structural reforms would raise investment not only by supporting savings, but also boosting stability and confidence.

Başçı also implicitly showed, as I had argued in my March 13 column, that the lira’s weakness was not because of the euro-dollar exchange rate. The lira was the least volatile emerging markets currency until Jun. 2013. After Fed Chairman Ben Bernanke’s tapering announcement and the Gezi protests, it became one of the most volatile, and its relative volatility surged after Erdoğan’s tirades against the Central Bank.

Erdoğan said on March 12 that his meeting with Başçı had ended “positively and with a consensus.” Economists surveyed by business channel CNBC-e seem to have taken this to mean that he will let the Central Bank to stay on hold at the rate-setting meeting on Mar. 17. With the Fed’s own meeting the next day poised to rattle markets, this would be the smart thing to do.

At the end of the day, however, it wasn’t Başçı, but the markets, who took Erdoğan to school. He probably realized that his insistence on lower rates would result in an economic crisis, costing him the June elections. But I don’t think he has given up on his push for lower rates, especially given the economic slowdown signals from last week’s industrial production and current account data, or more generally what his advisers call “the new paradigm” of a weaker lira.

In that sense, I wish Başçı had also explained the consequences of a plunging lira- even though he did go through the impact of the perceived monetary policy stance on the exchange rate, and the effect of the exchange rate, in return, on inflation. Or explained that the impact of lower policy rates on the economy would be much weaker than Erdoğan takes it to be- and with a considerable lag.

The Governor may be saving them for his next meeting with the President and his economic brain-team. It is safer to take it slow with them. So much “new” information can short-circuit their brains.