For years, Recep Erdogan had insisted that Turkey’s galloping inflation was caused by interest rates being too high. He flatly refused to accept mainstream economic thinking which taught that only punishingly high interest rates can reign in the painful hyper-inflation his country had to suffer over recent years.
In quick succession he fired one central bank governor after the other who dared to resist his eccentric views, with dire consequences for the exchange rate of the Turkish lira. As the currency plummeted, import prices shot up, foreign capital scrambled for the exit and consumers and local enterprises saw their purchasing power rapidly dwindle.
Yet in spring this year, some asset managers and financiers in the US started to question if the Fed’s interest rate policy of keeping interest rates higher for longer may actually fuel inflation instead of fighting it.
For most economists this sounded like heresy. But these heretics, among them weighty figures like Rick Rieder, global chief investment officer of the world’s largest asset manager BlackRock, raised some valid points. Was the autocratic, not-very-bookish president of Turkey right, after all?
Central banks all over the world believe the only way to tame inflation is by raising interest rates. This policy is meant to weaken demand in the face of stretched supply. Burdened by the higher cost of credit, consumers would spend less, reducing demand and thereby bringing prices down. Enterprises suffering from weaker demand and higher credit costs on the other hand would hire fewer hands and buy less supplies, thereby making households poorer. The latter would reign in spending even more. Rising unemployment and stagnating salaries would be the price to pay.
We know now that things did not work out as planned. Inflation proved to be harder to tame, despite the unprecedented tightening of financial conditions. Consumers and corporations had higher cash reserves than anticipated, insulating them from higher credit costs. Both mortgage holders and enterprises had locked in low rates for years to come. Consumption, bottled up by the lockdowns, exploded, first for goods, then and still now for services. YOLO was the new motto. Prices for goods came down sooner, not so much by throttled demand but by matching supplies.
Now, two years after the Fed started its interest rate hikes, things seem to “normalise”: defaults on credit card and car loans are rising in the US, and wages, job openings and employment numbers are coming down. Consumers are becoming more price sensitive,
benefitting only low-cost supermarkets like Walmart.
In Europe, things worked out quite differently. Consumers and enterprises are more dependent on bank loans. The interest rate transmission was more immediate. The ECB, alas, had to hike regardless of economic weakening, which was augmented by falling exports to China and elsewhere: The interest rate differential to the US had enfeebled the euro, thereby importing inflation via higher materials and energy costs. Employment and manufacturing suffered quickly, while inflation remained sticky.
Rieder et al argue that rising interest rates have done little to throttle the economy as was planned. Before March 2022, when rates started to rise, the US economy grew at 2.5% annually. Now it still grows at 2.8% (2Q24). Unemployment is still moderate; it rose from a historical low of 3.8% to admittedly 4.3% in July 2024.
But these unemployment readings have to be understood in the context of rising labour participation. Many new entrants to the job market are still “unemployed”, as they have no job yet. This is different to workers made redundant.
Salaries are still growing in the US. The US stock market index S&P 500 was 4,358 in March 2022 and is 5,592 at the time of writing. Corporate profits are still holding up nicely, and not just at money printers like Nvidia, the chip maker (50% profit margin). Presidential candidate Kamala Harris is populistically campaigning against “price gauging”.
Rising interest rates have done little to throttle the economy as was planned- Andreas Weitzer
The interest rate heretics ask whether the US economy is not booming despite higher interest rates, but because of them? They employ two arguments. The first goes like this: when for many years after the GFC interest rates globally hovered around 0%, and in many cases becoming negative – creditors of Germany and other countries were essentially paying for the benefit of lending money to a worthy debtor – why did inflation not go up? Did zero interest rates perhaps facilitate disinflation?
It is not a very serious argument, because the circumstances were different. In these crisis years nobody picked up on the offer of cheap money, because they had no use for it. Credit demand stayed subdued, irrespective of how cheap the offer. Central banks were “pushing on a string”. No matter how much liquidity they pumped into the banking system, money supply would not grow. Both consumers and corporations were in a precarious situation and had no need for credit. Governments who should have taken up on the offer of free credit to support their economies decided to rather consolidate their budgets and pay down debt than to help their economies.
The second argument has more merit. Yes, consumers with modest incomes may have started to feel the pinch and reduced expenditure. But low-income earners cannot lower their outgoings indefinitely. They have to eat and to shelter regardless of their squeezed income. At a certain stage, social benefits will kick in, stabilising consumption at a minimum. Expenditure of lower-income households is thus a given. They will spend on average $32,000, no matter how dire the circumstances.
The highest income quintile (20%) in the US, representing 51% of total US income, are spending $134,000 annually, in comparison. They are responsible for 40% of total US household consumption. These households can afford to save too. These savings, now invested in money market funds and term deposits, create additional income for these high spenders, adding $50 billion per year to their spending habits.
It is therefore possible that lower interest rates, to be expected from September onwards in the US, could reduce the spending power of the more affluent ‒ a pivotal consumer segment. These households, cautioned to reduce spending, would lower overall demand for goods and services. This observation is only true at the margins and under given circumstances. A weakening US dollar, the consequence of lower rates, will to a certain extent start to import inflation. And higher interest rates, of, for instance, 8% per annum, would over time be demand destructive, no matter what.
These perhaps very valid observations are, alas, not applicable to Erdogan’s Turkey. With inflation at 62.1% at its latest reading and the Turkish lira at an all-time low (USD/TRY 5.71 in 2019, USD/TRY 34.08 in August 2024) only households with a hard currency income will scrap by. Everybody else gets poorer by the day. A more assertive interest rate policy (50% per annum) may have cushioned the rapid decline. But a real investment return of minus 12.1% will do little to strengthen the currency.
Turkey will continue to import inflation at high rates. The mismatch of imports (35.5% of GDP) and exports (23%) will all but guarantee that. An even more radical interest rate policy would help. But it is unlikely that Erdogan will agree.
Andreas Weitzer is an independent journalist based in Malta.