To hit its inflation target, the Central Bank would have to ignore Erdogan (lots of luck) and start focusing on a new target: the growth rate of broad money (M3). That would require the use of the Quantity Theory of Money (QTM).
The QTM states that MV = Py, where M is the money supply, V is the velocity of money, P is the price level and y is real GDP. When made operational and stated in terms of percentage changes in M, V, P and y, we can determine the “golden growth rate” for broad money. It is the money supply growth rate required to hit a stated inflation target: ΔM = ΔP + Δy - ΔV. So, the growth rate of broad money equals the inflation rate plus the percentage change in real GDP minus the percentage change in the velocity of money.
With this QTM equation, we use Turkish data to estimate the golden growth rate for money supply growth rate that would be consistent with the Turkish central bank’s 5% inflation target. We find that Turkish real GDP growth has averaged 3.85% for the past 10 years and that the percentage change of the velocity of money has averaged -4.34% for that period. If we plug these values into the QTM equation, we find that Turkey’s golden growth rate for money supply (M3) is 13.19% = 5% + 3.85% - (-4.34%).
Turkey Money Supply (M3)
But, Turkey’s broad money grew by 16.2% in 2016, and, as the chart below shows, Turkey’s central bank has consistently overshot the golden growth rate for broad money. Since Erdogan assumed office as the Turkish prime minister on March 14, 2003, Turkish broad money growth has averaged a whopping 18.8%. It’s no surprise that inflation rates have been above the Central Bank’s target. It’s also not surprising that the lira has depreciated by 55% against the greenback since Erdogan assumed power.
Erdogan’s referendum “win” will prove to be a loser for Turkey’s inflation and the lira. Indeed, inflation will continue to ratchet up, while the lira will continue to weaken.
The Fall of the Turkish Lira