The Turkish lira has capitulated over the last two months. In this article, we will consider a basic monetary economic model to explain the USDTRY's movements over this time frame.

The Quantity Theory of Money

One of the earliest models of monetary economics is the quantity theory of money (QTM). It can be traced back to Copernicus in the 16th century but was popularised by Friedman and Schwartz in the '60s with their publication of "A Monetary History of the United States, 1867-1960."
The theory assumes four variables:
1. Money supply.
2. Inflation.
3. GDP.
4. The velocity of money.

It then suggests that two of the four variables are relatively constant - GDP and the velocity of money. However, money supply and inflation tend to vary. If inflation becomes a problem, the QTM suggests that the supply of money must be adjusted to restore equilibrium. I.e., according to the theory money supply should be used to regulate inflation

Clearly, there are simplifications and other econometric models will deal better with the inflation variable. However, in its simplicity, the QTM is very succinct in its point. If there is inflation, money supply needs to be altered. Reducing money will, holding everything else constant, lower inflation. This is economics 101.

Central Bank Independence

Another tenet of monetary economics is an independent central bank. To emphasise: an independent central bank is highly desirable; to the point that without independence a central bank cannot be effective in achieving its goals.

Central banks may have more than one mandate but the one common mandate they will all have is that of price stability. From the Turkish Central Bank website: "Monetary policy refers to decisions taken to influence the availability and cost of money in order to achieve targets such as economic growth, employment growth and price stability" and "to meet inflation targets, the Central Bank manages aggregate demand and inflation expectations by using policy rates and other monetary policy instruments. " https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Core+Functions/Monetary+Policy

However, the independence of Turkey's central bank has long been questioned. President Erdogan has fired three heads in two years over policy.

Turkish Inflation

Inflation in Turkey is running at 20%. This is abnormal price appreciation and requires an appropriate response. Using the QTM, an obvious potential solution is to reduce money supply (i.e. raise the interest rate) to moderate the overheated economy.

However, this is the exact opposite of what has transpired. Strangely, rates have dropped 3%, from 18% to 15%, over the last two months. This has had a devastating effect on the Turkish lira.

The TRY has devalued against the USD at a parabolic rate. It is currently trading at over 12.30, the catalyst for the sharp decline being an inappropriate monetary response to Turkey's high inflation. President Erdogan has defended the rate cuts, maintaining the move to be an "economic war of independence." This will have the effect of reducing Turkey's purchasing power, which means that it will import further inflation i.e., imports will cost more and this will be passed on to consumers and business.

Semi Tumen, the former central bank deputy governor who was dismissed in October tweeted the following, "We need to abandon this irrational experiment, which has no chance of success, and return to quality policies that will protect the value of the Turkish lira and protect the welfare of the Turkish people." The ATR (black line under price) has jumped to levels not seen since 2018, and we would posit that until monetary policy is freely available to use in order to achieve central bank targets, the USDTRY is likely to remain volatile.

Additional sources:
cnbc.com