Turkish inflation lessons for the Federal Reserve

The Federal Reserve is not alone in now subscribing to unorthodox monetary policy doctrines. It is being outdone by the Bank of Turkey, which under President Erdogan’s thumb, has embraced the most unorthodox of interest rate policies with highly untoward economic results. One has to wonder whether Turkey’s unfortunate experience with monetary policy experimentation might not hold some cautionary lessons for the Fed.

Among the more glaring of the Fed’s current deviations from monetary policy orthodoxy has been its seeming abandonment of Milton Friedman’s fundamental teaching that monetary policy operates with long and variable lags. By this, Friedman meant that central banks should not expect that their policy actions would achieve instantaneous results. Rather they should allow some time for their monetary policy moves to yield results.

Over the past 40 years, Friedman’s teaching had guided earlier Federal Reserve Boards to anticipate building inflationary pressures in the economy and to take timely monetary policy action to defuse such pressures. By contrast, the Fed under Chairman Jerome Powell now keeps informing us that it has no intention to scale back its present ultra-easy monetary policy until it sees actual evidence that inflation is exceeding its target. By so doing, it heightens the chances that by the time the Fed chooses to act, it will be too late to prevent inflation from taking hold.

Another way in which the Powell Fed is deviating from monetary policy orthodoxy is its movement away from a defined inflation target. Over the past 40 years, the Fed had found inflation targeting an effective way to keep inflationary expectations well anchored. The Powell Fed now is taking a very much more relaxed attitude toward inflation targeting. It is doing so by indicating in rather general terms that, after undershooting the Fed’s inflation target for many years, the Fed will now tolerate inflation exceeding the Fed’s 2 percent target for some time. By so doing, it risks un-anchoring inflation expectations.

Yet another way that the Fed seems to be defying monetary policy orthodoxy is by continuing its large-scale bond-buying operations at the pace of $120 billion a month. It is doing this even at a time that it recognizes that there is considerable financial market froth and that the economy is recovering strongly. Particularly striking are the Fed’s continued purchases of $40 billion in mortgage-backed securities each month even at a time that the U.S. housing market is experiencing a housing market boom on the same scale of that which preceded the 2006 U.S. housing market bust.

But the Turkish central bank’s departure from monetary policy orthodoxy has been even more extreme than the Fed’s. Under pressure from President Erdogan, who has now fired three central bank heads in less than two years, the Turkish central bank seems to be going along with Erdogan’s totally out of consensus view that far from being helpful in reducing inflation, central bank interest rate increases are a principal cause of higher inflation. This has caused the Turkish central bank to be very reluctant to raise interest rates even as inflation rises and the currency continues its downward spiral.

The results of the Turkish central bank’s monetary policy mismanagement have been devastating for the Turkish economy. Turkey’s currency has been the world’s worst performing currency this year, while over the past 18 months it has lost almost half of its value. Meanwhile the country’s international currency reserves have been depleted and inflation is now running at close to 17 percent. 

To be sure, the U.S. inflation outlook is nowhere nearly as dire as that of Turkey. But with U.S. consumer price inflation now at 5 percent and accelerating, the Fed would do well to look at the Turkish experience with unorthodox monetary policy so as to avoid making the same policy mistakes.

A key lesson for the Turkish experience is that failure to raise interest rates in a timely fashion to head off inflation risks allowing inflation expectations to become un-anchored. That, in turn, risks intensifying inflation pressures as the public advances its expenditures in anticipation of higher prices down the road. It also risks inviting both domestic residents and foreigners to sell the currency in anticipation of future losses in its value.

The Fed’s current need to keep inflation expectations well anchored is all the more crucial in today’s U.S. context of a record peacetime budget stimulus and of around $2 trillion in excess household savings that is being held largely in low yielding bank deposits. If households begin drawing down on those savings for fear of higher prices down the road, we would get a further unwelcome increase in aggregate demand. That, in turn, could lead us down Turkey’s well-trodden path of rising inflation and a depreciating currency.

One has to hope that the Fed will learn from Turkey’s experience and shake off its current inflation denial. Maybe then it will return to monetary policy orthodoxy before it is too late for a nasty bout of inflation.  

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.