Mahfi Eğilmez: Interest is a real trouble

The Central Bank of the Republic of Türkiye Monetary Policy Committee, which met on September 21, raised the policy rate by 500 basis points to 30 percent.

Since the meeting in June, which was the first chaired by the new governor Hafize Gaye Erkan, the Central Bank's total interest rate hikes over the last four months have reached 21.5 points.

Economist Mahfi Eğilmez published a noteworthy article on interest rates on his own website. Mahfi Eğilmez's article titled "Interest is a Real Trouble" is as follows;

"It is stated in all religious texts that interest is forbidden (haram). However, this issue of prohibition has been interpreted differently in various societies, religions, and sects over time. Some began to ignore the prohibition, some applied it in its strictest form, and some chose to apply interest in another form and under another name. In this article, I will not dwell on which perspective on interest is right or wrong. That subject is both a topic that has been much debated and continues to be debated, and I have previously written my views on this matter. Today, I will focus on the trouble that the misapplication of interest will create for the economy.

When central banks set the interest rate they apply to the funds they lend to banks incorrectly, many problems arise. Setting interest rates lower than inflation leads people to lean excessively toward buying real estate, foreign currency, gold, and the stock market instead of keeping their savings as deposits in national currency at banks. This pressure leads to the formation of bubbles in those areas and an increase in inflation. If the economy in question is open to dollarization and dependent on imports, and the central bank has set the interest rate far below inflation (negative real interest rate), then in addition to these, there is also a rise in exchange rates. The rise in exchange rates causes imported inputs used in production to become more expensive in terms of national currency and causes inflation to rise even further through costs.

The issue most wondered about here is how and why the interest rate applied by the central bank when lending to banks affects the economy.

The current practice in our country is in the form of the Central Bank providing repo-backed loans to banks with a one-week maturity. The interest applied to this loan is called the policy rate. The policy rate, which the CBRT recently increased to 30 percent, is the annual interest rate of the weekly debt it provides to banks. The policy rate hike made by the CBRT has two meanings: (1) The CBRT will henceforth provide weekly loans to banks at 30 percent interest instead of 25 percent annually. In other words, the resource cost of banks will rise. However, since the amount of funds banks obtain from the CBRT occupies a proportionally small place in their total resources, the negative contribution of this interest rate hike to bank costs is limited. (2) When the CBRT raises the policy rate, it sends a message that it predicts inflation will remain high in the future and that it will continue to take measures to curb it. The purpose of this message is to emphasize that measures are being taken against inflation and to try to influence future expectations in a positive direction. The main effect expected from raising the policy rate is this change in expectations that is being attempted to be created.

Banks, taking into account the cost increase in their resources as a result of the central bank raising interest rates and the signal that inflation will rise in the future, raise their loan interest rates while simultaneously raising deposit interest rates to avoid losing deposit customers, taking into account competitive conditions. For these to happen, there must be no intervention in banks other than interest and reserve requirements. If there are direct or indirect interventions in banks, for example, if restrictions have been placed on loans or if an obligation has been imposed such as buying low-interest government bonds if they exceed certain magnitudes, this system works differently. Then the decisions and practices taken by banks may not be in the consistency we describe here. When such interventions are made to banks, demand for foreign currency continues due to deposit interest rates remaining quite low compared to inflation and the continuation of negative expectations, and therefore exchange rates do not decline even if the CBRT raises interest rates. Undoubtedly, there are other reasons related to the economy or social indicators for exchange rates not declining.

The most important reason why expectations do not change as desired despite the CBRT raising interest rates is that we have constantly experienced ups and downs regarding interest rates in the economy in the past and have never been able to achieve stability and the set target. Such unstable practices and missed targets in the economy make it difficult for expectations to turn positive. People form expectations by looking at how decisions taken in the past were implemented and what results they yielded, rather than the decisions themselves. For example, they look at what happened to the CBRT Governor who raised interest rates to fight inflation.

Interest is truly a trouble; if mismanaged, it can single-handedly turn the economy upside down. Even if it is later steered correctly and steps are taken in that direction, there must be a set of supporting measures alongside it. If those do not accompany it, making the right decisions on interest rates alone cannot fix the economy."