Vicious Cycle: The Inflation-Exchange Rate and Interest Rate Trap

Years ago, in my doctoral thesis, I used the concept of the "finance motive" to emphasize the importance of keeping interest rates at a level that allows for physical investment. Because if physical investments do not increase, inflation is inevitable...

By physical investment, I did not mean only social fixed capital investments like housing, but rather investments that spread added value through components and relatively reduce dependence on imports. Over the years, Turkey's export and import capacity has increased. We call this, in short, the foreign trade volume. The ratio of foreign trade volume to national income has moved from the 40 percent band to the 55-70 percent band over the last 30 years. In other words, we are talking about a foreign trade value equivalent to more than half of the national income.

However, the country has achieved its openness performance through foreign trade deficits, just as it did during the Ottoman era, meaning dependence on imported inputs has gradually increased. This describes an overheated economy where demand for foreign currency is high. This "dynamic" network of relationships not only fails to sufficiently grow Turkey's place in the global chain created by international monopolies, but also creates channels that strengthen the transfer of surplus value abroad. Thanks to the facilitators created by financialization, capital flight through the "Net Errors and Omissions" item causes further damage to the economy alongside the current account deficit.

In this environment, inflation anchoring at 30 percent keeps the pressure on exchange rates and interest rates on the agenda. According to the newly announced Domestic PPI, the real exchange rate index is above 100 for the first time since 2023. In other words, the TL has a value above the inflation value of the goods produced by domestic producers. However, there is no situation as exaggerated as claimed. When we look at the real exchange rate in terms of CPI, it is at 106, still well below the 2017 value of 120. That is, we are facing an exchange rate value that almost reflects the increase in consumer prices. Yet, the producer is complaining. Why? Because the import dependency, which can be explained by the foreign trade deficit we mentioned above, forces the producer to specialize in "new" and "efficient" goods for export...

EXCHANGE RATES WATCH THE PATH OF INTEREST RATES

So, does an increase in the exchange rate work? I don't think so. Just like the effect created by money coming in through asset peace programs, the export boom brought about by an exchange rate increase does no one any good. The neoliberal system cannot find a remedy for this situation with its decaying proposals either.

Thus, we have re-entered the trap of stopping inflationary pressure from within with interest rates and inflationary pressure from without with a relatively low exchange rate (a relatively valuable TL). We call it a trap because while investments (in terms of domestic and foreign capital) are not increasing, the helplessness of monetary policy is revealed by the rise in the foreign trade deficit... Unfortunately, the monthly foreign trade deficit is entering the 10 billion dollar threshold, and the annual one is approaching the 100 billion dollar mark. July was a flare with 10.4 billion dollars.

This is an issue that cannot be explained solely by energy prices. The 65 percent dependency on intermediate goods imports cannot be broken. This is an issue that lowers the value-added of exports and determines the impact of imports on exchange rates and inflation. In this environment, let alone interest rates being a remedy, their harmful effects are observed in all sectors. Especially in textiles and automotive...

Yet, if measures could have been taken through fiscal policy to improve income distribution in the short, medium, and long term, returning inflation to 20 percent would not have been impossible, even despite the war.

The destruction caused by constant political problems and institutional behaviors that are not in line with democracy on the justice mechanism, and the relationship of this phenomenon with the investment and value-production process in the economy, is also an important issue. If the economy is not discussed healthily, it becomes difficult to produce solutions, and trust is lost... The perception that things will not go well rises. We can understand this not through the consumer confidence index, but through the eyes of the ordinary citizen...

On the other hand, indices like "Big Mac," whose validity weakens day by day, also struggle to explain the inflation-exchange rate equation. Because in a fast-food chain, as a fast-moving consumer good, the biggest cost factor is rent rather than wages and input costs. This makes it difficult for the masses to measure international value through common or similar goods. The index that explains the real exchange rate with unit labor costs is still below 100 (end of 2025). This data (RULCs) shows that the determinant role of wages on the exchange rate is limited.

IF INCOME REDISTRIBUTION DOES NOT IMPROVE...

In summary, perception managers who are trying to stimulate competition through the exchange rate and unblock exports need to review the relationship between exchange rates and inflation based on historical data. They are in a mood of high "complaining" because they know this. On the other hand, the dream of stopping inflation with an excessively (relatively) valuable exchange rate should not be exaggerated. This can only create a pseudo-perception. Essentially, the institutional mechanism that improves the relationship between income redistribution and productivity is important...

For example, last July, renewable energy usage exceeded half of total energy consumption (58 percent). This means that against the energy costs increased by the effect of the war, a cost advantage was achieved by increasing energy efficiency, even if only for a one-month summer period, if desired. Let us also note (for now) that this phenomenon is not reflected in diesel costs and is not a remedy for the increase in food prices. It is no longer interesting that in the same July, despite a period of abundance in production, no decrease (minus) was observed in food prices. Because keeping profitability alive through inflation is preferred more than efficiency work to reduce costs.

A market economy cannot be managed with a perception created through the arbitrariness of pricing in situations where the market is not supervised at all and the institutional structure is weakened. We cannot think that we can prevent inflation at the expense of a further decline in the registered economy. Especially, inflation can never be prevented while inequality and exploitation continue. The ground where the ordinary citizen can seek their rights and where law meets justice means that the seeds of improvement in the economy are sown.

Life teaches us that it is not possible to lower inflation by reducing real wages and increasing interest rates further. We will only be able to observe a decline in inflation when market dynamics are directed not by short-term profit greed, but by the institutional infrastructure of development, democracy, and egalitarian approaches. We must seek the way out of the trap we mentioned at the beginning not in exchange rates or interest rates, but in institutional mechanisms that organize social networks in an egalitarian way. Inflation is not just a financial and economic indicator; it is a political indicator. The political boiling point we are experiencing will determine the fundamental dynamic of inflation...