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Erdogan Dares New Central Banker to Think Differently on Rates

Cagan Koc and Constantine Courcoulas
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Erdogan Dares New Central Banker to Think Differently on Rates

(Bloomberg) -- President Recep Tayyip Erdogan may finally get to crow “I-told-you-so.”

For now at least, a coincidence of favorable data and timing would appear to vindicate Erdogan’s assault on economic orthodoxy, which holds that borrowing decreases when interest rates rise, curbing inflation as consumers spend less. Turkey’s president believes the opposite is true, and lower rates bring price growth down.

Thanks to a more stable lira, weak demand after recession, and distortions from year-on-year comparisons, Turkish inflation could soon be in single digits for the first time in over two years. And the central bank will almost certainly oblige on Thursday with a rate cut of as much as 4 percentage points, according to some analysts surveyed by Bloomberg. Most see a reduction of 275 basis points to 17%.

But economists worry that Erdogan may be confusing correlation with causation. Much of the credit for the disinflation and the room to cut rates should go to the outsized monetary tightening delivered last year. And by exerting ever greater sway over monetary policy, Erdogan risks wrecking what’s left of the central bank’s credibility.

What’s more, the benefits of stimulus could be short-lived if it prompts a market backlash and starts another cycle of inflation and currency upheaval.

Just last year, the central bank came under pressure from Erdogan to refrain from raising rates, contributing to a crash in the lira by leaving Turkey’s assets vulnerable against a resurgent dollar.

The worry is what would happen next. Lack of a disciplined monetary policy means a “renewed collapse in the lira” is only a matter of time, according to Commerzbank AG. Rabobank is warning that a “major policy mistake could be in the making.”

“Erdogan intends to rewrite books on monetary policy, reiterating his unorthodox view on the relationship between inflation and interest rates,” said Piotr Matys, a London-based strategist at Rabobank.

Loose Language

At the moment, Erdogan thinks he has the upper hand. Megaphone monetary policy has been all the rage in Turkey since the ouster of Murat Cetinkaya -- who held rates for nine months after a massive hike -- as central bank governor in July. While his replacement, Murat Uysal, has kept mum on rates for over a month, the president liberally weaves strident calls for easing into his stump speeches and interviews.

Uysal had only been in office a few weeks when he slashed the benchmark by 425 basis points. Hours later, Erdogan said Turkey’s biggest rate cut in at least 17 years was “not enough.”

Then days ahead of this week’s meeting, Erdogan suggested Turkey will lower borrowing costs to single digits soon and inflation will follow suit. Speaking on the economy Monday, he said he favors the Islamic risk-sharing model over charging interest.

“You will see that inflation will slow as interest rates fall,” Erdogan said in another speech on Saturday. “You are going to say: ‘Our president told us so.’"

Erdogan’s distaste for high rates has been linked to Islamic proscriptions on usury. In his view, producers have to pass on their higher borrowing costs to customers, so they raise prices.

On Edge

The verdict is still out on how long the market will tolerate an emboldened Erdogan and a mostly silent, pliant central bank. While the lira held up well after Cetinkaya’s dismissal, its fragility has been on full display since Erdogan started to turn up the heat last Wednesday.

Turkey’s currency is the worst performer in emerging markets against the dollar since Sept. 4, the day Erdogan said rates will fall further and unveiled next year’s target for economic growth that many analysts deem overly ambitious. It traded weaker for a fifth straight day on Wednesday, on track for its longest losing streak since May.

Expectations that the European Central Bank will pull off a rate cut and restart quantitative easing may give Uysal extra cover on Thursday. But chances are, price pressures will catch up with Turkey. Although inflation has slowed by more than 10 percentage points since a high in October, the deceleration will likely begin to fade in the last two months of this year.

“Over a longer horizon, the trend toward overly loose monetary policy risks exacerbating Turkey’s age-old vulnerabilities by fueling the twin dynamics of inflation and attendant currency weakness,” said Phoenix Kalen, a strategist at Societe General SA in London, who expects the central bank to cut its one-week repo rate by 250 basis points.

(Updates with lira’s performance under ‘On Edge’ subheadline.)

--With assistance from Harumi Ichikura.

To contact the reporters on this story: Cagan Koc in Istanbul at ckoc2@bloomberg.net;Constantine Courcoulas in Istanbul at ccourcoulas1@bloomberg.net

To contact the editors responsible for this story: Onur Ant at oant@bloomberg.net, ;Lin Noueihed at lnoueihed@bloomberg.net, Paul Abelsky

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