The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101’ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”


Unfocused vacation musings on money – part 3

I am going to keep this short and make just a few observations.

The Egyptian tragedy – fix the economy please  

Cato’s Dalibor Rohac has a good comment on Egypt. This is a bit of it:

“What needs to be done? First, the country’s unsustainable fiscal situation calls for decisive action. That means the subsidy problem must be addressed. Subsidies account for one-third of the total public spending in Egypt — more than education and healthcare spending combined. Unfortunately, the benefits of subsidies accrue mostly to wealthy Egyptians — those who buy a lot of the commodities that are subsidized.”

I think one of Egypt’s biggest problems is massive trade restrictions and the subsidies obviously are part of that story. The trade restrictions are not only directly economically harmful, but it is also a major source of corruption. As always excessive regulation leads to corruptions as the public in general tries to “circumvent” these restrictions by bribing customs officials.

Should China combine Fisher and Frankel’s ideas? 

As I was writing my piece on Chinese producer prices yesterday I got the idea that maybe China should try to combine the ideas of Irving Fisher and Jeff Frankel. Frankel wants to target the product price (PPT), while Fisher suggested his Compensated Dollar Plan (CDP). The idea with CDP was that the Federal Reserve (that was Fisher’s example) should revalue or devalue the dollar versus the gold price dependent on the development in the price level. Hence, if the price level rose by 1% the dollar should be revalued by 1% and similarly if prices dropped by 1% then the dollar should be devalued by 1%. The purpose was to use this mechanism to stabilize the price level.

Similarly the People’s Bank of China could introduce a Compensated Renminbi Plan. However, instead of using the gold price as the policy “instrument” the PBoC could manage the RMB against a basket of industrial metals such as copper, aluminum and steel. Then the RMB could manage the RMB against this basket (with a fluctuation band) to stabilize Chinese producer prices around a 2 or 3% level path. That would mean that the RMB would be fixed, but rather managed against a basket of industrial metals. Hence, the RMB would be gradually revalued or devalued to hit the targeted producer price level. With a fluctuation band and forward guidance from the PBoC most of the adjustments would probably be market determined. That could ensure both a fair predictable development in the RMB and provide nominal stability.

Come to think of it – maybe it should be the Fisher-Frankel-Hall standard. Hall for Robert Hall who suggested the ANCAP commodity standard. ANCAP stands for ammonium nitrate, copper, aluminum and plywood.

Finally it should be said that this is not a variation of my (and Frankel’s) Export Price Norm – industrial metals is the input to the production in China rather than the output.

Fed SF sounds very Friedmanite – yields are low because inflation expectations are low

Read this:

Long-term U.S. government bond yields have trended down for more than two decades, but identifying the source of this decline is difficult. A new methodology suggests that reductions in long-run expectations of inflation and inflation-adjusted interest rates have played a significant role in the secular decline in yields. In contrast, standard statistical finance methods appear to overemphasize the effects of lower risk premiums and reduced uncertainty about future inflation.

Nikkei rebounds, but what about inflation expectations? 

The recent rebound in the Japanese stock market has been pretty impressive and combined with the gradual and continued weakening of the Japanese yen it could indicate that the Bank of Japan is regaining some credibility. However, looking at inflation expectations it seems like that is not entirely the case. Hence, inflation expectations remain well-below 2%. Therefore, the BoJ should certainly not be complacent. It might be that the stock market is doing great, but the BoJ cannot declare victory before inflation expectations hit the targeted 2%.

Keynes 1923 on the ‘hot potato effect’ (or maybe hot coffee effect)

Monetarists stress the importance of the so-called hot potato effect in the monetary transmission mechanism. During my vacation reading I came across Keynes’ description of the hot potato effect from A Tract on Monetary Reform. See here:

Keynes potato 1

keynes potato 2

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