Turkey's economy remained under the shadow of high and fluctuating inflation for many years. Within this scope, one of the main factors in the transformation process that was implemented after the 2001 crisis was the Central Bank of the Republic of Turkey's (CBRT) transition to the price stability-oriented policy and provision of instrument independence. Also, with the contributions of the relevant regulations, we achieved bidding farewell to high inflation, which was our chronic headache.

During this process, the interest rates that were used as active political instruments also became one of the critical actors that had a role in economy. While monetary policy is endeavoring to enable price stability, it achieves this to a great extent by creating an effect on overall demand. And the whole system of channels indicating in what way politics affect demand and inflation is called the “monetary transmission mechanism”.

It is healthy to handle the latest discussions regarding interest-inflation-growth within the framework of this mechanism. In this regard, I would like to draw a general frame of the mechanism, and look at what kind of a flow the interest conducts in the system.

Our mechanism consists of several phases. According to this, in the first phase, the interest decisions have an influence on market interest rates, asset prices, expectations and exchange rate channels.

On the second phase of the mechanism, this interaction influences the saving, spending and investing behaviors of investors and consumers. And such decisions that shape domestic and foreign demand play a role in overall demand and growth.

The third phase comprises the channels that reach the targeted price stability. The internal prices shaped with demands directly influence inflation. Another chain that contributes to this phase is the exchange rate, as the changes in exchange rates affect imported product prices, and consequently inflation. It must also be taken into account that the interest rates directly contribute to inflation by affecting the costs.

Nevertheless, it must be noted that various channels in the mechanism are also affected by some other developments that are not controlled by the Central Banks. The changes in factors including global market dynamics, commodity prices and risk premia can influence the mechanism and carry the direction and activity of monetary policy into a different dimension.

By considering the fact that each single channel may react to interest change to a different extent and they might affect each other, I would like to briefly mention the functions of each channel.

Channel of interest : The interest change announced by the Central Bank might cause a change in the marginal cost of loans and lead banks to regulate the rates they implement. This would mean influencing the market interests, and supply and demand of funds. Thus, the monetary authority penetrates into demands by influencing the decisions of both households and firms.

Channel of asset prices: The changes in interests also influence the domestic asset prices. For instance, in case the Central Bank decreases the interests, an increase is expected in demand for face value, which leads to a price-rise in the relevant assets. One of the probable results of this is the firms' increasing investments by increasing their values. A similar effect is always seen on individuals' assets and has a potential to be reflected on consumption. There are other details at this point including housing but I would not like to go into the details in this article.

Channel of Expectations: The interest changes also have a potential to influence the expectations and confidence regarding the future of economy. For instance, it can be expressed that the interest decisions shape the perception concerning the future and direct the investment decisions. Interest change helps households to question some fundamental factors including interest change, job, income and inflation; and determine their spending according to this. The conservation of the independence and reliability principles of the Central Banks do also have an importance in the context of this channel.

Channel of exchange rate: The interest changes also influence the demand by playing a role in the exchange rate in the mechanism. The reason behind this is the fact that the real interest rates are the main determinants of the portfolio investments made in the relevant country. To give an example, a capital outflow that might be observed following an interest rate cut devalues the national currency. And this positively affects the overall demand with a change that contributes to net exports.

On the other hand, it is required to underline that it is hard to determine to what extent the monetary policy would make a net effect on exchange depending on other various factors including foreign interest rates.

Also, it should be expressed that another factor in the chain of interest-demand route through the channel of exchange is the level of foreign currency at the loans and assets of individuals or firms.

Aside from influencing the economic activity through these ways, exchange rate also plays a direct role on inflation through the channel of export prices. For this reason, it is possible to express that the exchange channel is one of the rapidest channels of the mechanism. This channel also bears importance in terms of financial stability particularly for the developing countries like Turkey.

While influencing the economic growth through those transmissions, the interest change also directs inflation at the final phase. Consequently, it is inevitable for the Central Banks that prioritize the price stability to act by calculating demand's effect on inflation.

After mentioning fundamental factors concerning interest flow, I would like to underline again that the mechanism is affected by some noises. Along with some frictions such as exchange rate transitivity, dollarization and reserves, uncontrollable shocks also have some reflections on the transmission. Consequently, the final result of political decisions depends on a conjuncture at which all these parameters have a role.

All these factors indicate that it is required to carefully protect the security and focus more on the structural reforms in order to obtain more effectual results by decreasing the noises in the operation of monetary policy.

All in all, we end up in the same place no matter where we depart.

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