Turkey was already sliding toward a crisis before Trump imposed tariffs to achieve a political objective.
The FOMC is especially focused on potential spillovers to the U.S. economy, namely Turkey-related trade flows and banking vulnerabilities in the U.S. As they emphasize, they are not the central bank of the world and their mandate is full employment and price stability at home. This, of course, does not sit well with EMs, who are already under pressure from the steady rise in U.S. rates.
From the FOMC’s perspective, potential spillovers from a crisis could affect the dollar, trade, and the financial system–and, in turn, monetary policy, not because of macro impacts, but because of a return to a risk management posture.
Today, this is a story of vulnerabilities in Turkey, exposed by an unanticipated shock. Yes, there are spillovers to other EMs, especially those with weaker fundamentals. The impact appears to be manageable at this point, but getting more intense for a small number of countries. And there are some euro-area banks with significant exposure. Again, this looks manageable. But I remember that was also the reaction during the early stages of the subprime crisis.
The Collapsing Lira
The collapse of the lira gets the most attention, understandably, because it is large, ongoing, and the immediate concern concerning spillover is less trade than it is domestic financial vulnerabilities that had not been corrected.
This is a Minsky moment, at least for Turkey: A large unanticipated shock to an economy with large domestic and external imbalances. It was an accident waiting to happen, or already underway. And Trump’s policies amplified the emerging crisis underway.
A Tug-of-War Game
You might remember playing tug-of-war at camp, when two people pull on opposite ends of a rope, with the goal being to bring the rope a certain distance to their side? One could say this is the tug-of-war between a much smaller economy already under stress and a very large economy that will hardly suffer if it loses. So the winner seems obvious. Of course, it is really a tug of war between two intransigent leaders, Trump and Erdogan.
Domestic Policy in Turkey
But the response of domestic policy can lessen the impact on the domestic economy. Fiscal stimulus? Erdogan wants it, but it’s not happening. So, missing in action. Monetary policy is apparently the only game in town, though supervisory authorities also have a role. True, a “corrective” monetary policy response to a currency crisis–higher rates–would increase the pain on the domestic economy. But some combination of higher rates and currency controls may be the recipe for arresting the currency crisis.
Even when the run on the lira is over, there will be lingering effects for Turkey. Their ability to fund externally in a foreign currency will be diminished for years to come, and borrowing costs will be higher because of a
persistent risk premium. The corrective monetary policy, if it comes, will increase the domestic pain on the way to a more stable domestic economy.
Spillovers will be concentrated especially in less resilient EMs. Those who improved policy and financial soundness by a combination of higher reserves, floating exchange rates, and sound domestic policy are faring better, but all are feeling the effect. Some are vulnerable, but the impact looks manageable. And there are large banks in the euro area that are exposed to a lot of non-lira Turkish debt. Supervisors say this is manageable. Don’t they always! But it will be hard to even identify any small spillovers to the U.S. and, if identifiable, they will be so minor that they won’t create macro problems.
As for the effect on U.S. financial conditions, there hasn’t been all that much. Equities dipped briefly before rebounding, and in any case, remained at high levels. And since the escalation, the ten-year Treasury yield edged down slightly, while corporates moved up slightly. The most notable change is with the dollar, which is up about another percent, on the net. While the appreciation of the dollar is something to keep an eye on, the changes in financial conditions to this point are certainly not enough to shift the near-term outlook for monetary policy given the economy’s momentum.
Recall that in 2016 the FOMC retreated to risk management again and again–delaying a rate hike that it otherwise might have made. So, should we rethink the rate hike that we and almost everyone else expect in September 2018? No. It’s a different environment. Back then, it was challenging to move away from the zero bound. Now, we are much closer to overheating than to the zero bound. The story remains: Go directly to r
star, no delays.