Why Turkey’s Experiment With Unorthodox Monetary Policy Failed in the Most Predictable Way Possible

Imagine being informed that removing the sprinklers is the best course of action when you enter a room where a fire is spreading. Beginning about 2010, the Turkish government requested that its central bank carry out this kind of intellectual exercise, and the bank complied for the better part of ten years. The idea was unique enough to be noteworthy: lowering interest rates was the way to price stability because higher rates actually increase inflation rather than reduce it. In a late-night argument, it’s the kind of idea that sounds contrarian but could pass for sophisticated.

When political pressure was applied to a national economy over a long period of time, the results were neither complex nor unexpected. Between 2003 and 2021, the Turkish lira lost about 420% of its value in relation to the US dollar. The rate of inflation reached 85%. And the central bank is still attempting to reconstruct something that resembles regular monetary policy after years of forced capitulation effectively destroyed its credibility.

Turkey’s Monetary Policy Experiment — Key Facts & Timeline

Instead of a crisis, the story opens with relative strength. Turkey was in a fairly stable position in 2010. It had a low debt to GDP ratio. A market indicator of default risk, credit default swap rates, were favorable. Recently, the nation was upgraded to investment grade, indicating that foreign capital markets considered the risk to be manageable. This is significant because governments’ desire for low-cost debt financing is a common justification for political pressure on central banks. In 2010, Turkey was not in that predicament. What followed is both more striking and instructive because the pressure to keep rates low was ideological, motivated by a government belief system rather than a fiscal emergency.

The Central Bank of the Republic of Turkey’s response to rising inflation changed from active resistance to near-indifference around 2011, which is what economists who have studied this period the most closely noticed. The standard rule that a central bank should raise rates by more than one percentage point for every percentage point increase in inflation, known as the Taylor principle, was no longer met. The bank’s policy rate eventually started to deviate from what conventional monetary economics would recommend. Rates decreased as inflation increased. The government used a straightforward and efficient method to enforce this: central bank governors who disagreed were dismissed. In four years, four of them. Each replacement received a clear message.

The repercussions came one after the other, almost like they were outlined in a textbook. The exchange rate changed first. The lira started to weaken more quickly than the currencies of other emerging market nations with comparable external circumstances, such as Brazil, Mexico, Indonesia, and South Korea. The lira entered what researchers called a “free fall” by the time the most dramatic phase of rate cutting arrived in the fall of 2021, when the CBRT lowered its policy rate by a cumulative five percentage points while inflation was already four times the official target.

Prices came next. In a short period of time, Turkey’s inflation rate increased to 85%, about fifteen times its declared target. It was an odd experience to watch the sequence of events from the outside; the result was precisely what standard macroeconomic theory predicted, arriving at roughly the pace and in roughly the order the models suggested, as if the economy was determined to prove a point.

The financial repression that followed the collapse was what made Turkey’s situation much worse than a straightforward case of loose monetary policy. The government forced banks to hold long-term government bonds and used administrative pressure to cap market rates in response to market forces driving up long-term borrowing costs, which occurred even as the policy rate dropped because lenders demanded compensation for the inflation they could anticipate. There were times when Turkey’s ten-year lira borrowing rate was lower than its dollar borrowing costs.

This arrangement was illogical because the lira was rapidly depreciating and Turkish inflation was running at many multiples of US inflation. The financial system became more and more a network of administrative decisions rather than market signals, and it was only possible through coercion rather than credibility. Then came the exchange-protected lira accounts, which were revealed at midnight, presumably in an attempt to slow down the market’s processing speed. It was priced almost instantly by financial markets. In essence, the government transferred the risk of fluctuating exchange rates from individual depositors to the government budget. Within hours of the announcement, credit default swap rates skyrocketed.

Looking at the entire arc of this episode, it seems that the Turkish experience is more about what happens when the technical requirements of monetary credibility clash with the political logic of short-term popularity than it is about unconventional economics. Independence of central banks is not a theoretical institutional preference. It exists because there is almost always an incentive to keep borrowing costs low and growth figures favorable in the short term, and because the costs of caving in to that incentive typically come later and are concentrated among those with the least ability to absorb them. Turkish households saw their purchasing power decline, their savings diminish, and the value of their currency depreciate at a rate faster than that of nearly every peer economy. At its worst, the real policy rate was roughly negative 50%, which meant that anyone who wasn’t compelled by law or circumstance to hold Turkish liras was actively losing money in terms of inflation.

Rates were raised by 2,650 basis points as part of the normalization effort that started following the May 2023 elections. There is a great deal of tightening done with what seems to be sincere intent. However, the lira is still losing value, albeit more slowly, and inflation is still close to 60%. It takes time to restore central banks’ credibility after years of deliberate damage. Markets create expectations based on trends, and Turkey’s established pattern of lowering rates when inflation rises and replacing governors when they object is difficult to reverse with a few announcements of rate increases.

The CBRT may be able to regain some of the institutional standing it enjoyed in the early 2000s with continued dedication and time. It’s also possible that no rate decision can resolve the complex web of financial repression, exchange-protected accounts, and distorted market signals on its own. A politically motivated rate cut in 2023 sent the zloty sharply lower almost immediately, giving Poland a taste of this. It seemed that anyone who paid attention could learn the lesson. For more than ten years, Turkey had been broadcasting it loudly and in real time.