In a significant move to combat years of escalating inflation, Turkey’s central bank, led by former Wall Street banker Hafize Gaye Erkan, has implemented a bold 250-basis-point increase, pushing the key interest rate to 42.5%. This strategic decision comes on the heels of an intensive seven-month tightening cycle, totaling a substantial 3,400 basis points.

Anticipation of this adjustment was widespread among analysts, who now ponder the possibility of an additional rate hike despite last month’s indication from the central bank about the imminent conclusion of current tightening measures.

The central bank, in an official statement, emphasized its commitment to swiftly conclude the ongoing tightening cycle while maintaining monetary tightness for sustained price stability. This decision has stabilized the Turkish lira and placed real rates in positive territory, aligning with end-2024 inflation expectations.

The market consensus, as mirrored in a recent Reuters poll, accurately predicted the rate hike to 42.5%. Future forecasts suggest a cautious continuation of policy tightening in early 2024, followed by a potential easing in the latter half of the year.

Projections for inflation indicate a peak at 70-75% in May, with the central bank aiming to bring it down to approximately 36% by the end of the following year through the ongoing effects of tightening.

Selva Demiralp, a professor at Istanbul’s Koc University and a former Federal Reserve economist, stressed the importance of sustained tightening. Demiralp noted, “While we can estimate the central bank’s reaction function, predicting President Erdogan’s response to monetary policy introduces an additional layer of uncertainty.”

Despite President Erdogan’s historical inclination towards rate cuts, he currently supports the prevailing policy. However, skepticism arises given Erdogan’s track record of dismissing central bank chiefs, casting doubt on Erkan’s ability to maintain course.

Confidence in the central bank’s leadership is evidenced by the recent drop in Turkey’s five-year credit default swaps, measuring default risk. From nearly 700 in May, they have now dipped below 300, with JPMorgan suggesting the potential for Turkey to issue record debt in 2024.

Nicholas Farr at Capital Economics remains cautious, predicting a further 250-point hike in January. He emphasizes, “Policymakers must commit to prolonged high-interest rates to effectively bring inflation down to single digits.”

This strategic policy shift not only addresses inflation but also aims to rectify chronic trade deficits, rebuild depleted foreign currency reserves, and attract foreign investors after a protracted exodus. However, the higher borrowing costs present challenges for Turkish citizens, complicating efforts to manage a cost-of-living crisis that has persisted over the past two years.

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By: Montel Kamau
Serrari Financial Analyst
21st December, 2023