prof. Dr. Selva Demiralp | Koç University Faculty Member
Since the beginning of the year, the central banks of nearly 90 countries have increased interest rates.
Nearly half of these countries have increased interest rates at least 75 basis points at a time, that is, about one-tenth of the inflation they have experienced.
One day after the last 75 basis points increase in interest rates by the US Federal Reserve during the week, the CBRT cut interest rates by 100 points.
While the rest of the world prefers to “fight against inflation at the expense of growth”, Turkey uses the opposite direction with “growth at the expense of inflation”. Is there such an alternative? Could it be that the rest of the world doesn’t want growth as much as we do?
If we persistently continue to cut interest rates while so many countries increase interest rates to fight inflation, and as a result, our inflation is many times higher than them, ‘Where did we go wrong? What do they see that we don’t know and raise interest rates?’ It’s good to ask.
The clearest answer to these questions is given by Fed Chairman Jerome Powell, who explained the reasons for the rate hike after Wednesday’s press conference.
“The slowing growth and weakening employment market as a result of high interest rates are troubling for the people we serve. However, this problem is not as great as that of failing to achieve price stability and then trying again.”
The FED is under intense pressure from the markets to avoid further interest rate hikes and even to start interest rate cuts as soon as possible, against the risk of slowing down the economy due to the interest rate hikes it has made since the beginning of the year.
Powell’s answer is a response to these pressures. He says that if we can’t achieve price stability by leaving the work we started today unfinished, we will pay a higher price in the future and does not take a step back.
It is a concept that we are very familiar with in these lands, first to go to interest rate hikes in order to reduce inflation, to start interest rate cuts halfway due to the pressures that followed, and finally to face higher inflation. At the point we have reached today, there is no longer any interest rate increase, albeit procedural.
It is not a coincidence that the inflation rate is 65-70 percentage points lower than ours in countries that can be in the same group as us, and even in Russia in the middle of the war.
The sad thing is that since the last quarter of 2021, interest rates have been lowered to support the economy and inflation has increased by more than 60 points, while seasonal and calendar adjusted unemployment has decreased by only 1 point.
Because on the one hand, the economy is tried to be kept alive with all the supports and resource transfers, on the other hand, inflation has a contractionary effect on growth and reduces employment.
Everyone wishes for growth, for the cake to grow, for everyone’s slice of cake to increase.
However, if you ignore inflation and do not implement policies that restrain inflation, it turns around and hits economic growth. Even if there is growth in an inflationary environment, the low-income segments cannot feel this because the income distribution is deteriorated. The slice of the pie they get is getting smaller, let alone getting bigger.
This is the main reason for Powell and the central banks to increase interest rates in order to eliminate inflationary pressures in his absence.
The cost of inflation and the cost of an interest rate hike
Central banks compare the two costs when making decisions. The first is the cost of interest rate hikes. An increase in interest rates slows demand by increasing the cost of borrowing. The slowdown in demand reduces inflationary pressures. On the other hand, the slowdown in production causes loss of employment, which is the problem that Powell talks about. But again, as Powell mentioned at the press conference:
“I wish there was a painless way to lower inflation, but unfortunately there isn’t.”
Central banks, which put the cost of tight monetary policy on one side of the scale, do not implement tight monetary policy on the other side, but put the cost of inflation out of control. Because just as interest rate hikes slow down the economy, inflation slows the economy down and creates employment loss. More importantly, the loss of employment due to inflation is permanent.
Inflation slows the economy by suffocating and uncontrollably. It dissolves purchasing power, weakens demand by impoverishing the people. Slowing production brings employment loss.
The forced slowdown due to inflation has a significant difference from the controlled slowdown brought about by an interest rate hike. The economy, which is cooled by raising interest rates, ultimately pulls inflation down. In an economy that is slowing down due to inflation, inflation hangs and does not fall on its own.
In other words, while a slowdown in the economy is inevitable in both scenarios, the main difference is “price stability”. The “controlled slowdown” that brings price stability is the most important contribution of the central bank to sustainable growth.
Because price stability brings low interest rates and macroeconomic stability. Persistent low interest rates and stability support an increase in investment appetite, which in turn supports an increase in potential growth rate and employment.
However, an economy forced to slow down due to inflation cannot experience a similar increase in production capacity. In other words, inflation not only hits today’s growth, but also undermines the country’s opportunities for future growth in production and employment.
For this reason, 90 countries prefer to prevent inflation with tight monetary policy and bear the cost of tight monetary policy, as it is seen as a “less costly” solution.
It is the job of the central bank to reduce inflation. After the central bank offers the least costly solution, who will shoulder this cost is the decision of the political authority.
Based on the fact that we will face the high inflation we live in sooner or later, the plans of the opposition parties, which announced their economic programs on transfer payments, unemployment insurance, and reduction of indirect taxes, are especially valuable in terms of reducing the cost of tight monetary policy.