Turkey's Volcker moment: snuffing out structural inflation.

• Author: Friedrich, Klaus

When Paul Volcker became Chairman of the Federal Reserve in August 1979, the United States was suffering from a long bout with stagflation. Consumer prices had increased by levels that had been unheard of for several decades and the economy was stalling. In fact, in the very month Paul Volcker took office, annual inflation stood at nearly 12 percent.

Volcker recognized that the real threat to the independence of a central bank--political interference by more short-term oriented politicians--can ultimately be thwarted only by the bank's determination to succeed in its basic mission, which is monetary stability. By 1979, it was clear that the Fed was failing and that a sharp turn in policy was needed.

Flence, Volcker and his colleagues on the Board of the Federal Reserve Bank took the courageous and controversial step of aggressively raising the so-called federal funds rate. Between August 1979 and June 1981, this rate rose from 11.2 percent to 20 percent. The net effect of this policy was a steady decline in and, more significantly, a lasting containment of inflation.

The Fed's return to positive real interest rates had a decisive impact on lastingly changing U.S. economic fortunes for the better.

Dealing with high inflation had also long been a reality in a number of emerging markets. In earnest, most countries began to tackle this problem in the early 1990s through a prudent combination of fiscal and monetary policy.

Turkey provides an interesting example, although it was a relative latecomer to such efforts. At the end of 1979, when Volcker took up his post, Turkey's inflation level stood at 81 percent. Over the next twenty-three years, Turkish inflation would average 63 percent per annum. The economic costs of this near quarter-century of inaction were high. These seemingly never-ending price increases wreaked havoc with the household finances of Turkey's citizens.

Failure in monetary policy to achieve greater price stability also made successive Turkish governments more reluctant to implement economic reforms. Their primary concern was to soften the blow of what is rightfully described as the most brutal tax on the poor. Necessary economic reforms, on the other hand, might have required additional, politically unpopular short-term sacrifices. Together, these two policy failures kept the country from realizing a crucial goal--expanding its middle class.

Starting in 2003, the steady implementation of prudent fiscal and monetary policies...