Turkey Cut Rates Into Rising Inflation and the Lira Collapsed
Conventional policy raises rates when inflation rises. Turkey did the opposite, deliberately and repeatedly, and the currency responded exactly as theory predicts.
The Orthodox Response
When inflation rises, the standard central bank response is to raise interest rates. Higher rates reduce demand, make holding the currency more attractive, and support the exchange rate.
A weaker currency raises the price of imports, which for an economy dependent on imported energy and intermediate goods feeds directly back into inflation. Defending the currency is therefore part of controlling inflation.
The Alternative Doctrine
Turkish policy from 2021 operated on a stated alternative view: that high interest rates cause inflation rather than restraining it, on the reasoning that borrowing costs are an input to prices.
Acting on that view, the central bank cut its policy rate repeatedly while measured inflation was rising, eventually into severe double digits.
The currency market did not need to resolve the theoretical debate. It simply priced the fact that holding lira paid a real return that was deeply negative.
The Currency Response
The lira depreciated heavily against the dollar and the euro over the period. The decline was not smooth, with several episodes of very sharp movement following particular policy announcements or personnel changes.
Central bank governors who resisted the direction of policy were replaced, repeatedly. Each replacement signalled that the policy would continue and produced a further move in the currency.
The mechanism was straightforward. Domestic savers converted lira into foreign currency and gold to preserve purchasing power. Foreign investors withdrew. Both flows pushed the exchange rate lower, which raised import prices, which raised inflation further.
The Interventions
| Measure | Outcome |
|---|---|
| Selling foreign reserves | Depleted reserves without holding the rate |
| Protected lira deposit scheme | State absorbed depreciation losses |
| Restrictions on foreign exchange access | Slowed but did not stop conversion |
| Pressure on banks and firms | Administrative rather than monetary |
The deposit protection scheme deserves attention. It compensated holders of lira deposits for depreciation against hard currency, effectively transferring exchange rate risk from savers to the state.
It slowed the conversion out of lira and created a large contingent fiscal liability that grew precisely when the currency fell most, which is the definition of an exposure that concentrates its cost at the worst moment.
The Reversal
Following elections in 2023, a new economic team was appointed and policy shifted sharply toward orthodoxy, with substantial rate increases.
The shift was welcomed by international investors and imposed real domestic costs, since the accumulated inflation and the adjustment required were both large. Unwinding an extended period of unorthodox policy is considerably more painful than not undertaking it.
What It Illustrates
The episode is one of the clearest natural experiments in modern macroeconomics, because the policy was pursued deliberately and consistently over several years with a stated rationale.
It demonstrates the practical function of central bank independence. Independence exists so that monetary policy can impose short term costs that are politically unattractive, and the Turkish case shows what happens when that constraint is removed.
It also shows how quickly currency markets enforce a view. Domestic policy can control the domestic interest rate. It cannot control the price at which the rest of the world will hold the currency.
The Bottom Line
Turkey cut interest rates while inflation accelerated, on the stated view that high rates cause inflation. The lira fell heavily, import costs rose, and inflation accelerated further, with reserve sales and a deposit protection scheme absorbing costs without changing the direction. The 2023 policy reversal confirmed the orthodox framework and required a painful adjustment that would have been smaller if undertaken earlier.