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Inflation in Turkey: a self-inflicted problem?

Inflation has been rising around the world as a combination of a recovery in demand and supply-chain issues have resulted in aggregate demand exceeding aggregate supply. Annual consumer price inflation at the beginning of 2022 is around 2.5% in China, 3.5% in Sweden, 5% in the eurozone, Canada and India, 6% in the UK and South Africa, 7% in the USA and 7.5% in Mexico. In each case it is forecast to go a little higher before falling back again.

Inflation in Turkey

In Turkey inflation is much higher. The official annual rate of consumer price inflation in December 2021 was 36.1%, sharply up from 21.3% in November. But according to Turkey’s influential ENAGrup the December rate was much higher still at 82.8%. Official producer price inflation was 79.9% and this will feed through into official consumer price inflation in the coming weeks.

The rise in inflation has hit the poor particularly badly. According to the official statistics, in the year to December 2021, domestic energy prices increased by 34.2%, food by 44.7% and transport by 53.7%. In response, the government has raised the minimum wage by nearly 50% for 2022.

Causes of high and rising inflation

Why is Turkey’s inflation so much higher than in most developed and emerging economies and why has it risen so rapidly? The answer is that aggregate demand has been excessively boosted – well ahead of the ability of supply to respond. This has driven inflation expectations.

Turkey’s leader, President Erdoğan, in recent years has been seeking to stimulate economic growth through a mixture of supply-side, fiscal and monetary policies. He has hoped that the prospect of high growth would encourage both domestic and inward investment and that this would indeed drive the high growth he seeks. To encourage investment he has sought to reduce the reliance on imports through various measures, such as public procurement favouring domestic firms, tax reliefs for business and keeping interest rates down. He has claimed that the policy is focused on investment, production, employment and exports, instead of the ‘vicious circle of high interest rates and low exchange rates’.

With the pandemic, fiscal policy was largely focused on health, social security and employment measures. Such support was aided by a relatively healthy public finances. General government debt was 32% of GDP in 2020. This compares with 74% for the EU and 102% for the G7. Nevertheless, the worsening budget deficit has made future large-scale expenditure on public infrastructure, tax cuts for private business and other supply-side measures more difficult. Support for growth has thus fallen increasingly to monetary policy.

The Turkish central bank is not independent, with the President firing senior officials with whom he disagrees over monetary policy. The same applies to the Finance Ministry, with independently-minded ministers losing their jobs. Monetary and exchange rate policy have thus become the policy of the President. And it is here that a major part of the current problem of rising inflation lies.

Monetary and exchange rate policy

Despite rising inflation, the central bank has reduced interest rates. At its monthly meeting in September 2021, the Turkish central bank reduced its key rate from 19% to 18% and then to 16% in October, to 15% in November and 14% in December. These unprecedented rate cuts saw a large increase in the money supply. M1 rose by 11.7% in November alone; the annual growth rate was 59.5%. Broad money (M2 and M3) similarly rose. M3 grew by an annual rate of 51% in November 2021. The cut in interest rates and rise in money supply led to a rise in nominal expenditure which, in turn, led to higher prices.


The cut in interest rates and rise in nominal aggregate demand led to a large depreciation in the exchange rate. On 1 September 2021, 100 Turkish lira exchanged for $12.05. By 11 January 2022 the rate had fallen to $7.22 – a 40.1% depreciation. This depreciation, in turn, further stoked inflation as the lower exchange rate pushed up the price of imported goods. (Click here for a PowerPoint of the chart.)

Attempts were made to stem this fall in the lira on 20 December, by which point 100 lira were trading for just $5.50 (see chart) and speculation against the lira was gathering momentum. President Erdoğan announced a scheme to protect lira deposits against currency volatility, guaranteeing lira deposits in hard currency terms. The mechanism adopted was a rise in the interest rate on lira deposits with a maturity of 3 to 12 months, thereby encouraging people to lock in deposits for the medium term and not, therefore, to use them to speculate against the lira by buying other currencies. Other interest rates would be unaffected. At the same time the central bank used foreign currency reserves to engage in large-scale purchases of the lira on the foreign exchange market.

The lira rallied. By 23 December, 100 lira were trading for $8.79. But then selling of the lira began again and, as stated above, by early January 100 lira had fallen to $7.22. The underlying problem of excess demand and high inflationary expectations had not been solved.

It remains to be seen whether the President will change his mind and decide that the central bank needs to raise interest rates to reduce inflation and restore confidence.

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Questions

  1. Until the pandemic, the Turkish economy could be seen as a success story. Why?
  2. What supply-side policies did Turkey pursue?
  3. Use either an aggregate demand and supply diagram or a dynamic aggregate demand and supply (DAD/DAS) diagram to explain what has happened to inflation in Turkey in the past few months.
  4. Explain the thinking behind the successive cuts in interest rates since September 2021.
  5. Why did the measures introduced on 20 December 2021 only temporarily halt the depreciation of the lira?
  6. Choose a country with a higher rate of inflation than Turkey (see second data link above). Find out the causes of its high rate. Are they similar to those in Turkey?