Obviously, this process helped the central bank policy rate decline radically, by 9.5 points in total in the last year. The central bank started to decrease policy rates from the 16.75 percent level on Oct. 23 of last year, and the level of borrowing rates had declined to 7.25 percent as of September.
Despite there being no high interest rate pressure on the real exchange rates (RER) today, the TL remains comparatively overvalued. This must have surprised those who constructed their arguments for this on the basis of the “high interest rate, low exchange rate policy” (HILE) of both the central bank and the government. What is striking is that the argument for an “overvalued TL” will definitely return, but this time along significantly different lines. If RER continues declining in an environment where there is no high interest rate pressure on the value of the TL, this will lead to further confusion. Let's explain once again what is really happening.
As is well known, the central bank's unique legal responsibility is to achieve price stability. In this process, the target rate of inflation is fixed jointly by the central bank and the government. However, the central bank is fully autonomous in achieving the target through the use of the available policy tools. Among effective tools, the short-term interest rate policy is the most significant. In the case of inflation deviating during the targeted interval, the governor of the central bank is obliged to write a letter to the economy minister explaining the reason behind the departure and suggesting required measures to correct the process.
However, the central bank's use of such an interest rate policy has created serious disputes among economic players. To reiterate a previous discussion, there has been a continuing perception by the public that the central bank is pursuing an HILE policy for many reasons.
In order to clarify the ongoing disputes, it behooves us to provide a short theoretical explanation here. In an open economy, according to the Mundell-Fleming model, an economy cannot simultaneously maintain (i) a fixed exchange rate; (ii) free capital movement; and (iii) an independent monetary policy.
This principle is frequently called the “Unholy Trinity,” the “Irreconcilable Trinity,” the “Inconsistent Trinity” or the Mundell-Fleming “trilemma.” The implication is that no one can “have their cake and eat it too.” In that regard, there has been continuous argument in choosing between pegged exchange rates and monetary policy autonomy. Leaving aside the extreme views on this topic, a country has absolutely no autonomous monetary policy under normal conditions. In the modern world, maybe with the exception of China, capital controls are not favored as they would introduce numerous distortions.
Under these conditions, the Mundell-Fleming trilemma asserts that a country has to choose between reducing currency volatility and running a stabilizing monetary policy; it cannot do both. Despite this, let us give all three possible scenarios below, remembering that a country must pick two out of the three. First, it can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (as China does today). Second, it can choose to leave capital free and stabilize currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.
Third, it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate. Obviously, as there are no perfect models, these models also contain both positive and negative elements. Therefore, a country must carefully make its choice by considering its needs and accepting the risks. The third model has been followed in Turkey since 2001. That is, capital movements are free, the exchange rate is also flexible, yet Turkey has the capacity to exercise an independent monetary policy.
The significance of the third model is its compatibility with an inflation-targeting regime. Inflation targeting, on the other hand, also relies upon certain facts in Turkey. Since Turkey exhibited two major sources of risk prior to the 2001 crisis such as high and chronic inflation and also currency risk, this regime is found to be most advantageous. Empirical evidence has shown that inflation targeting would bring concrete results in terms of preserving price and employment stability. Moreover, it is also compatible with economic growth and with tying down inflationary expectations. However, there are some important conditions for the success of inflation targeting to be noted here. These are fiscal and financial soundness, significant support from financial institutions, avoidance of fiscal dominance of the public sector, and finally, a certain degree of flexibility (a constrained discretion) should given to the central bank in order to guarantee the credibility of inflation targeting in the event of unexpected but harmful contingencies on inflation. (To be continued)
