What happens in Turkey when inflation in the US slows?
12-month inflation in the US unexpectedly rose to 9.1% in June, prompting the Federal Reserve to keep the pace with rate hikes at 75 basis points in July, increasing the interest rate to 2.5%. While hopes that inflation was past its peak were dashed, fears of stagflation dominated the global markets, as the Fed was expected to tighten monetary policy even further, as it was felt to have reacted too late to inflation.
With inflation approaching double digits, spreading across the economy and eroding purchasing power, almost everyone agrees that the US central bank will focus on bringing inflation down regardless of the recession on the horizon. Two consecutive quarters of contraction in the US economy, coupled with the very strong employment data that immediately followed, has led to the acceptance that the Fed will keep its fist clenched in the fight against inflation without a backward glance. The most important manifestation of recession fears was the decline in oil prices. WTI crude oil, the US benchmark, has fallen 28% since its last peak in early June and is trading at around $90 a barrel. Brent crude, the international benchmark, has also fallen 24% since June to around $95. It has fallen more than 30% from its March peak of $140 following the invasion of Ukraine. The rapid decline in oil prices resulted in a slowdown in US CPI inflation to 8.5% in July. However, food and rent prices, which are the main concern for consumers, continue to rise.
While the slowdown in headline inflation was welcomed by the markets, what is critical for the economy is whether the US inflation has started to recover from its peak and how many years the expected decline will take to reach the 2% target beyond 2022. The course of US inflation is determined by two key factors: domestic demand and commodity prices, particularly energy. The Fed's rate hikes will undoubtedly slow US consumer demand, which has outstripped supply in the wake of the pandemic. The first signs of this have started to emerge, but it is not yet possible to talk about a sufficient slowdown. This is already a sign that the bank's rate hikes will continue. The other factor is oil/energy prices. The two main reasons for the decline in oil prices are the aforementioned fears of recession, which will slow demand and outweigh the inflexibility of supply, and Russia's success in continuing to sell oil despite sanctions. However, not everyone believes that oil prices will continue to fall.
Analysts at Citigroup wrote that if a bad recession hits the global economy, prices could fall as low as $65 by the end of the year; even without a recession, with current dynamics, prices could fall to about $85 by the end of the year. Goldman Sachs lowered its forecasts this week, but said it expects oil to rebound as demand is stronger than many thought. According to Goldman, Brent will rise to 110 dollars in the third quarter and 125 dollars in the fourth quarter. The International Energy Agency (IEA) has raised its oil demand forecast for this year as some countries switch from natural gas to oil in energy production. More strikingly, and further limiting supply, the IEA forecasts that Russia's oil production will fall by 20% early next year as the European Union's import ban kicks in. If the Brent price falls to around $80 per barrel, US inflation could fall to around 5-5.5% by the end of the year. If the oil price rises to $110 or more on unexpectedly strong demand, as Goldman expects, this would push the Fed's rate hike beyond what is considered reasonable.
For the time being, the expectation is for the Fed rate to rise from the current 2.5% to 4% by the end of the year. The problem is that even if the potential for lower oil prices pushes US CPI inflation down to the 5% mark, it will take longer and cost more than expected to bring inflation from 4-4.5% to the 2% target. In other words, even if the Fed sees CPI inflation fall from a peak of 9.1% to around 5% in 2022, rate cuts will not start in 2023, even if signs of recession, including in the labor market, become tangible after mid-2023. On the contrary, US inflation, which will fall relatively "easily" from 9% to 5%, will take much longer to fall from 5% to 2%. So, even if the Fed completes its rate hikes in 2023, rate cuts will not easily be on the agenda before late 2024.
Reflections on Turkey's markets and economy
We should also assess the potential repercussions of this story on the Turkish economy. The slowdown in US inflation, concerns about a global recession and, in particular, the fall in oil prices have had a positive impact on global markets. Hopes have been rekindled that the Fed will limit its rate hikes in response to slowing inflation and that the rate peak could be lower than expected, or even that a real soft landing could take place in mid-2023. All these factors also led to a depreciation of the dollar index.
In the aftermath of this change in sentiment, Turkey's 5-year CDS risk premium fell from around 900 to around 650 and the 10-year eurobond yield fell to around 9.5%. While the Russian currency reserves increased by $7-8 billion, the $20 billion requested from Saudi Arabia appeared on our radar. Despite all these news and developments, and despite the fact that the tourism season saw a peak, the USD/TL did not fall an inch from around 17.9. The reason for the fragility in the TL is that $17.5 billion of the $32.5 billion current account deficit in the first half of the year was due to the net errors and omissions item of unknown origin, and $12.3 billion of the central bank reserves were used to finance the current account deficit. The New Economic Model (NEM) is, of course, the reason for this situation.
Therefore, the positive sentiment in the US as it becomes clear whether inflation has returned from its peak is unlikely to last long once the level of stickiness in US inflation and the seriousness of the Fed are understood. It will also take some time to clarify whether supply constraints or economic stagnation will weigh on oil prices.
In the run-up to the elections, while we will be watching the course of inflation in the world economy, the pace of interest rate hikes, and the impact of balance sheet tightening measures, the Turkish economy will go through a period of foreign exchange shortages, the complex measures to avoid the abandonment of the NEM will further exacerbate the economic imbalance, external debt payments will come under pressure, and inflation will rise. Against the backdrop of the realization that inflation in the US will not converge quickly to 2% despite a gradual decline, the Turkish economy will continue to experience the negative effects of misguided economic policies on the TL.
*She is an economist with 28 years of professional experience and a columnist on economy/politics on web-based media. She was the Director of Research and Strategy at Egeli & Co. Asset Management, previously was the Turkey Economist of UniCredit Menkul Değerler A.Ş. as the Director of the Research Department; the Chief Economist and the Manager of the Research Department at Ekspres Invest; the Economist at Raymond James Securities; and Ege Invest; an Analyst of the Research Department at Global Securities, and Karon Securities. She received her undergraduate degree in Business Administration from Middle East Technical University in 1995, before receiving her M.A. degree in Economics from Hacettepe University.
She is the mother of a lovely daughter and runs the family farm producing raisins and grains in the city of Manisa/Saruhanli, located in western Turkey.