Turkey: It's complicated...

Source: Foreign Affairs

It's complicated...

Remember when it was cool to put "It's complicated" as your relationship status on Facebook? Most "complicated" relationships were actually not relationships at all, but people still did it all the time. Thankfully, the novelty has faded. Anyone claiming to be in a complicated relationship is either in a complicated relationship or ignorant of social media meta-trends.

But Erdem Basci and Recep Tayyip Erdogan, the governor of the central bank of Turkey (CBRT) and the Turkish Prime Minister, respectively, actually have a relationship that is genuinely complicated. You won't find any passive aggressive posts on their Facebook walls, but make no mistake: it's complicated.

Don't talk about history

You're not supposed to talk about the past on a first date, but history is everything in this relationship. The complicated dynamic between Basci and Erdogan stems from Turkey's decades-long battle against inflation. As the chart below shows, inflation remained highly elevated and volatile until the turn of the century. The turning point came in 2001 when the government made the CBRT an independent entity, charging it with a single mandate: maintain price stability. Since then, the economy has expanded at 5 percent on average, driven by strong household consumption and exports, and supported by stable prices.

Source: Capital IQ

Before inflation came under control, everybody wanted essentially the same thing: stable prices. But now, with inflation expectations anchored, the relationship between Turkey's fiscal and monetary authorities has become more complicated because each side wants something slightly different, sometimes demanding different policies. Erdogan needs economic growth to galvanize his support base as he prepares to make a run at the presidency. On the other hand, Basci, recognized as last year's Central Banker of the Year, must achieve price stability. Erdogan's objective demands more accommodative monetary policy, while Basci would prefer to keep rates on hold.

It's not you...

Every central banker in the world has a complicated relationship with his or her president. Have you ever heard of a president who cares more about price stability than economic growth? To resolve this fundamental tension, enlightened countries have laws that grant central bankers the independence to conduct monetary policy according to a well-defined mandate (normally targeting full employment, price stability, or both). Indeed, the most important reform that enabled Turkey to stabilize prices was the 2001 Law on the Central Bank of the Republic of Turkey. And while the law provides for the CBRT to "support the growth and employment policies of the government" it prioritizes price stability over all else.

Now, the CBRT's independence appears to be under threat. Five months after Basci took extraordinary measures to anchor the lira and prevent a balance of payments crisis through aggressive monetary tightening, Erdogan started pressuring Basci to lower rates, calling the first rate cut "a joke" and admonishing Basci not to "make a mockery of this nation."

Sure enough, the CBRT announced its second consecutive monthly rate cut on Wednesday, even though inflation has started to tick up (see chart below) and growth remains strong -- hardly the time to lower interest rates. Pointing to these trends as well as the tension in Iraq (which poses a major risk to Turkey, given its dependence on Iraqi oil), Citigroup noted: "We struggle to find a good justification for the CBT’s rate cuts in May and June."

Source: Citigroup

When you notice red flags...

Run. That's what any decent dating coach would advise, and that's precisely what Basci should do today. Succumbing to Erdogan's short-sighted and self-serving growth ambitions puts Turkey at risk. We know from last year (and two of my previous posts) that Turkey remains vulnerable to a decline or sudden stop in capital flows. With these rate cuts, Turkish real interest rates are negative, making Turkish assets even less attractive to foreign investors. For a country that just escaped a balance of payments crisis, these moves appear extremely irresponsible.

By accommodating his overbearing partner against his better judgment, Basci threatens to make the same mistake as a boyfriend or girlfriend dreaming that things will change for the better. Erdogan will continue bullying the CBRT until Basci takes a stand. Now is the time for Basci to reaffirm his commitment to the principles enshrined in the 2001 law by chartering a path that protects price stability, bolsters the lira, and restores credibility to the CBRT. Right now, he's letting a complicated relationship get the best of him.