A System view for Central Bank decisions

Some of my readers might remember a commercial that was very popular in Turkey in the 70s. In this commercial about thermal insulation, the apartment attendant receives complaints from some of the apartment residents that the heater is low and they are ?getting cold, while he receives complaints from others that the heater is burning too much and they are hot, and he rushes between different complaints. Apartment residents all together complain by asking “Is our apartment manager sleeping? “

So, what does this commercial have to do with topic of the day, the policy rate decisions given by the Central Banks, which was the subject of this week all around the globe?

In this article, I will try to explain with an analogy the functioning of the decision-making mechanism of central banks, which have the leading responsibility for the price and financial stability of the economy. In fact, while I aim to make the decisions of the Central Banks and their effects on the country's economies more understandable, the relevance of the commercial I mentioned will become apparent on its own.

Now let's think of the global economy as the apartment building in the aforementioned commercial. Let each flat in the apartment represent a country. Let's assume that in this apartment, instead of a central heating system, each flat has an independent heating mechanism. Thus, every flat owner can adjust their flat's thermostats, i.e. heating control systems, to the desired flat temperature. In this way, the thermostat of each flat tries to control the flat temperatures by opening and closing the hot water valves. When the hot water valves are opened, heat spreads from the radiators to the rooms in the flat and when the desired temperature is reached, the hot water valves are closed. This on-off process continues automatically so that the temperature remains within a certain band. If we want to manage this process manually instead of an automatic control such as a Thermostat, we will act according to whether we are cold at home, not with heat sensors, and we will open or close the heating valves ourselves.

The operation of the temperature control mechanism I have described is exactly the same as the operating principles of today's central banks. How? Central banks try to keep inflation under control while aiming for price stability. While doing this, they increase or decrease the policy rate by taking into account the monthly and annual values of various parameters. Going back to our analogy, room temperature is related to inflation, and inflation indices such as consumer inflation index or core inflation are the sensors that measure the temperature, and the policy rates are equivalent to the central heating hot water valve.

The fine line that Central Banks follow is because the action they take in inflation targeting also affects economic growth. So, it is not enough to just control the temperature as a simple thermostat does, there is also another parameter they need to pay attention to, economic growth…

What needs to be considered here is that this parameter is a parameter that reacts negatively to the actions taken for inflation, which is the parameter we primarily want to control. Tightening monetary taps to reduce inflation slows growth and, in certain cases, causes unemployment to rise. For this reason, there is a fine balance, a combination of science and art that must be followed in interest policy in order not to achieve so called "soft landing".

It is possible to diversify this analogy in many different ways, but it would be useful to continue by discussing another parameter that the central banks of countries with current account deficits such as Turkey should pay attention to: exchange rates. Let's proceed by comparing countries like Turkey, which has a current account deficit of approximately 60 billion $ a year, to apartments with poor thermal insulation in our analogy. Countries that need to find foreign resources to maintain the economic cycle due to structural disorders in the economy are like apartments that lose heat due to lack of insulation and need to find an extra source such as an electric heater to warm up, and if there is no extra source, they have to stay in cold.

Just as it is necessary to pay for the electricity spent, foreign sources have a cost. Short-term portfolio investments, called "hot money", think about the interest they will earn. In other words, they look at the policy rate determined by the central banks and the amount of interest they will earn overnight. The long-term investors will look at the legal functioning of the country and the existence and transparency of institutional mechanisms to ensure the security of their investment, regardless of the return on investment. If these do not exist, these resources will prefer other countries.

In such a situation, if we go back to the commercial I referenced at the beginning, although the addressee of the complaints seems to be the running apartment attendant, the real responsible party is the management that does not insulate its apartment, that is, a government fostering an economic cycle that constantly creates a current account deficit by not making the necessary structural reforms in its country, and failing in the fields of law, transparency and institutionalism.

If you have any questions, please contact Alper Eker

[email protected]