Real and nominal shocks–and the rate of interest

THERE is little debate that monetary contraction was a central cause of the Great Depression in the United States. The U.S. money supply declined 33% between the business cycle peak in August 1929 and the trough in March 1933. Financial panics were widespread, real interest rates rose sharply, and credit contracted greatly. The Federal Reserve’s failure to respond to the banking panics and plummeting output during the Great Depression is surely one of the great mysteries of the 1930s. Since the 1980s many an academia tried to evaluate the failures of monetary policy back then. For what concerns us here, was the main culprit the rate of interest that somehow could not adjust to new circumstances? Because the rate of interest is the main policy tool of central banks even after quantitative easing misalignment – or staying ‘behind the curve’- for too long could potentially be harmful in either direction. The CBRT’s decision has thus a positive signaling effect, especially before the November Eurobond issuance.


It may all have started with Irving Fisher and the Great depression. For one thing, Cole and Ohanian reviewed twenty-years ago the main mechanisms identified by economists to explain the observed pattern of the real effects of monetary policy during the 1930s, namely: (1) Lucas and Rapping’s (1969) unexpected deflation model, by which an unexpected monetary restriction would lead to a lower labour supply, insofar as workers, having adaptive expectations, always expect that the deflation of prices and monetary wages will no longer exist in the next period, and they therefore respond to unexpected deflation by lowering their labor supply. (2) The debt deflation model of Irving Fisher (1933), by which deflation, by making the burden of real debts heavier, would cause firms’ bankruptcies, and a collapse in demand. (3) The sticky wage hypothesis, by which, in the presence of nominal wage rigidities, a general decrease in prices would induce an increase in real wages, thus causing a decrease in labor demand. (4) Theories centered on the role f banking disruptions induced by deflation that would have caused the efficiency of financial intermediation to decrease. By comparing deflation in 1929-1933 to that in 1920-1921, the authors exclude Lucas and Rapping’s (1969) model and Fisher’s (1933) hypothesis. To the first they object that deflation was more likely to be expected in the 1930s than in the 1920s, because the nominal interest rate was lower during the 1930s. This weakens Lucas and Rapping’s (1969) model propagation mechanism, which is based on unexpected deflation. As to Fisher’s (1933) debt-deflation model, they note that, although the level of private debt as a proportion of output was higher in 1929 than in 1920, output dropped more sharply during the 1930s than during the 1920s, even if deflation was less severe.


Had the Great Depression been a normal business cycle, it should have ended much earlier than it actually did. By the same oken, should the COVID-19 shock prove to be of the measurable uncertainty type, it would possibly end earlier than envisioned; that is before 2022. This remains to be seen. Once the effects of the TFP (total factor productivity) negative shock were exhausted, the economy should have recovered its steady-state growth path. In Cole and Ohanian’s (1999) simulations, output should have recovered its trend level by 1936, if the measured shocks to TFP in the 1930s had been the sole ”impulse mechanism” for the economic cycle. The TFP was back to its trend level in that year. However de-trended data show that in 1939 output was still a good 25% below its trend level. This is an early example of what the IMF calls “scarring” now. In other words, scarring took a decade back then. Now it is expected to last three years. The observation that the recovery failed to happen in the mid-1930s led Cole and Ohanian to argue that the Great Depression was not only the result of a temporary shock that caused a fluctuation around the trend-growth path, but that it was probably the outcome of a mixture of a temporary shock with some other permanent shocks that caused the growth path itself to shift downward. Hence, the question is whether the current shock is a mixture of many a shock that bear on both trend and cycle. I think it is. Certainly it is so in Turkey. Thus, there is no panacea for the Turkish economic shock. It is deeply-rooted and complicated.


Were real rates constant for an extended period in the past decades? Did expected nominal rates rise at the same rate as expected inflation? If this were so, expected real rates would be stationary. This was Irving Fisher’s hypothesis back in the early 20th Century. Accordingly expected inflation determines the nominal rate of interest and the real rate stays put. However, the Tobin hypothesis claimed that real wealth -measured in terms of financial assets – remains constant. Real wealth accrues as money and the capital stock. What inflation does is to curtail the demand for money and because the sum is constant, demand for capital goes up. Because the production function is subject to diminishing returns, the marginal productivity of capital falls, and real interest rates also fall. Nominal nterest rates increase but at a lower rate than expected inflation. Does this make sense? Does it make sense to impose this kind of behavior on a variable (interest rate) that might or might not generate the kind of mechanism described by Tobin? Has demand for capital (investments) been up during the period of negative real rates? In the past, I concluded that if we add the variance series generated by GARCH modelling of inflation to the Fisher equation in addition to the level of inflation, the greater impact of inflation on interest rates would come from the variance. Put differently, expected inflation qua level alone wouldn’t raise the nominal rate enough to keep the real rate constant, but adding inflation volatility could bring the results closer. Besides, Granger causality is two-sided, and interest rate movements increase the volatility of inflation also – but not expected inflation itself. If one aims at lowering real interest rates, she should lower the volatility of inflation. By the same token, she ought to stabilize the exchange rate first and foremost.


The CBRT looks set to move in the right direction. The decision to raise the policy rate to 10.25% is on the one hand ‘too little’ but it may not be ‘too late’. It depends on both the volatility of inflation and of the exchange rate. If the exchange rate can be put into a disciplinary box, say 7.55-7.75, then an additional 100 basis points hike can do the trick. Before that, obviously, both the overnight funding and the Late Liquidity rates should be raised in tandem with the policy rate, which the market priced in right after the decision. They ought to adjust towards 11.75% and 13.25% respectively. Should this happen the long end of the curve might be tilted downwards and CDS may fall. As such, even in this scenario, TRY deposits don’t offer much in real terms. Asset dollarization can only be prevented if TRY rates jump to an attractive level. In this respect, one could utter ‘the sooner the better’ because the credit boom is over. The CBRT sees that domestic demand recovered quickly due to the credit effect and inflation rose in tandem. Given deeply negative TRY rates, dollarization went on. This has nothing to do with any kind of speculative attack because there are no overseas investors left in the first place. FX demand is triggered by both debt repayments of corporates and by households that didn’t find TRY assets attractive. Rendering real interest rates constant at near zero levels for an extended period in order to stimulate demand for investments (capital) in the manner of Tobin or even worse trying to prevent debt deflation by allowing inflation to rise in the way Fisher had envisioned is a very weak argument and is counterproductive. It would never do if a small open economy is dollarized and debt is largely FX-denominated.

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