Under pressure from President Recep Tayyip Erdogan, Turkey’s central bank cut interest rates while most of the developing world raised them, sending the Turkish lira into a tailspin.
The lira has lost 31% of its value during 2021 and more than 80% since 2013. With consumer price inflation running at 20% year-on-year as of October, Turkey faces hyperinflation.
Essential imports including more than a hundred categories of medication began disappearing from stores earlier in the fall.
Turkey’s central bank began cutting its benchmark interest rate on August 12, when it stood at 19%, to 16% today, triggering the lira’s free-fall.
That seems deranged, but there is a method to Erdoğan’s madness. The vast majority of Turkey’s wealth is in homes rather than securities, and Turkish home prices continue to rise faster than the blistering inflation rate.
Turkey’s middle-class hedges against inflation in the housing market, and real interest rates well below the rate of inflation keep the housing bubble going.
I called attention to this game in an August 2020 analysis (“The Talented Mr. Erdogan”).
This sort of manipulation is close to its best-used-by date. Sensitivity of the Turkish inflation rate to the exchange rate is rising. Inflation is accelerating as the lira falls.
As the chart below indicates, earlier devaluation of the lira produced relative modest price increases in the past. With each downward ratchet of the currency, though, the ensuing price jump has become bigger.
I calculated the changing sensitivity of Turkey’s consumer price index to the currency using a regression method that divides the time series into several periods.
The beta of the Turkish Consumer Price Index (CPI) of the currency (the percent change of the inflation rate for every unit of change of the currency) has risen steadily as the lira depreciates.
The chart below shows the year-on-year change in the Turkish CPI as explained by year-on-year changes in the currency, taking into account this rising sensitivity (using an econometric technique called a breakpoint regression, in which the computer divides the time series into different periods to obtain a best fit).
As consumer inflation accelerates, the flight out of Turkish assets will eventually force up interest rates and crash the housing market – and likely with it Erdogan’s political fortunes.