The latest news have shown that inflation in Turkey stood at 24.5% y/y, compared to “just” 17.9% y/y last month. This prompted a well-justified, 500-pip depreciation of the TRY, with respect to the Dollar. It also provides me with the opportunity to discuss an important distinction when it comes to interpreting inflation results.
Remember that we have distinguished between supply-side (cost-push) and demand-side (demand-pull) inflation. As also discussed, demand-side inflation is always positive for the currency as it indicates that the economy is growing. The faster the demand-side inflation grows, the faster the economy will also grow. This should mean that more demand for the currency will exist domestically, allowing for less domestic money to flow abroad, which should appreciate the exchange rate.
Nonetheless, there also exists the dark side of inflation, which is driven by supply-side factors. As you may recall, supply-side inflation is affected by factors which increase the cost of production. These include wages and the cost of raw materials, with the latter being a stronger predictor of supply-side inflationary pressures, for reasons explained here.
In the case of Turkey, inflation was not caused by the economy’s growth but came as a result of the 25% depreciation in the Lira. Simple mathematics show that a 25% increase in the 17.9% July inflation rate would result in approximately 22.5%, close to what has been reported. The Lira’s depreciation is likely to have caused a severe increase in the cost of imported goods, with the blow to consumer spending becoming even harder as oil prices surged during the last few months. Given the increase in prices consumer spending power has most likely decreased as demand factors cannot adjust that fast to changes in the cost prices. Hence, this increase in inflation is likely to be bad for the economy of Turkey and thus should justify a depreciation of the currency. In addition, the increase in inflation is expected to continue if the Lira does not return to its previous levels.
An important question is how one can determine whether changes in inflation have been caused by supply or demand factors. The answer lies in examining the causes of inflation shocks: for example, if inflation changes by more or less in accordance to the change in bank lending and/or government spending, then we can gauge that this is caused by demand factors. However, if inflation increases by much more than these indicator would have implied and, in addition, the exchange rate is declining or wages are increasing by much more than justified by previous inflation rates, then the cause likely lies on the supply side and should be a cause for worry.
Still, as always, each case has its own characteristics and should be viewed individually and not draw conclusions based on generic rules-of-thumb. The traders’ task is to keep the above fundamentals in mind and ask the right questions at the right time before committing to a trade.
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