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Turkey's Macro View, Part 1: Tightening Interest Rate Spreads And Increasing Predictive Power Of The Relative Purchasing Power Parity (PPP) Relationship

Turkey's Macro View, Part 1: Tightening Interest Rate Spreads and Increasing Predictive Power of the Relative Purchasing Power Parity (NYSE:PPP) Relationship

DECEMBER 20, 2010

tags: Currency, Exchange rate, Interest rate, Middle East, Purchasing power parity, Recreation, Turkey, Turkish Lira

What do recent spreads between the Turkish interest rate and interest rates in the U.S. and the Euro area suggest about the behavior of the exchange rates between the Turkish Lira and the other two currencies?

Recent spreads between the Turkish interest rate and interest rates in the U.S. and the Euro area suggest that the behavior of the exchange rates between Turkish Lira and the other two currencies adjust according to the Relative PPP condition. As Turkey's CPI Index rate of change has dropped, Relative PPP has become an increasingly better predictor of future exchange rate changes [See Charts 1, 2, & 3]. In addition, the declining interest rate spreads witnessed primarly post-inception of the New Lira, exposes that exchange rate changes are less volatile, facing shorter swings from year-to-year. Also, as interest rate spreads have decreased overtime, exchange rates between the Turkish Lira and the other two currencies have adjusted faster and more closely correlated.

Chart 1: Turkish Inflation Rate Changes and Turkey's Interest Rate Differentials

Chart 2: Interest Rate Spread Behavior and Turkey's Inflation Rate Changes

Chart 3: Reliability of Turkey's Relative PPP Relationship When
Used for Determining Future Changes in the Lira/$ Exchange Rate