Turkey's central bank raises interest rate less than expected, to 17.5%

Turkey's central bank on Thursday hiked its key interest rate by 250 basis points to 17.5%, coming in below analyst forecasts of 500 basis points as the country's monetary policymakers embark on a long and painful mission to tackle double-digit inflation.

"Monetary tightening will be further strengthened as much as needed in a timely and gradual manner until a significant improvement in the inflation outlook is achieved," the bank said in a statement, after its interest rate decision.

The Turkish lira fell about half a percentage point against the dollar on the news, trading at 26.92 to the greenback. Earlier this week, the lira hit a fresh record low of 26.9 against the dollar over market concerns that the coming rate rise would be less than expected. The currency has lost 30% of its value against the dollar this year.

In June, Turkey lifted its interest rate for the first time in more than two years, after Turkish President Recep Tayyip Erdogan appointed policymakers who had vowed to implement economic orthodoxy to turn around the inflation picture.

Turkey steadily lowered its policy rate from 19% in late 2021 to 8.5% last March, as inflation ballooned, breaching 80% in late 2022 and easing to just under 40% in June. In its statement Thursday, the central bank reiterated its aim to get inflation down to 5% in the medium term — which many economists see as unrealistic at this rate.

Traditional economic orthodoxy holds that rates must be raised to cool inflation, but Erdogan — a self-declared "enemy" of interest rates who calls the tool "the mother of all evil" — vocally espoused a strategy of lowering rates instead.

Analysts reacted negatively to the news, with many calling it a mistake.

"Terrible decision and I think a mistake. Again under-delivering," Timothy Ash, emerging markets strategist at BlueBay Asset Management, wrote in an email note. "It will again play to the script of those saying that Simsek and Erkan don't really have a mandate to deliver real policy tightening," he said, naming Turkey's finance minister and central bank chief, respectively.

The bank's emphasis on a gradual tightening pace lends credence to some analysts' views that policymakers are reluctant to introduce larger and more drastic hikes, lest they hurt public sentiment and support for Erdogan.

"Guess this means small hikes, often but when inflation is close to 40% and CBRT's (the central bank's) own commentary is that it is going to rise in the short term these comments will fall on deaf ears. Sorry, trust in the CBRT is rock bottom and needs to be rebuilt by actions not words," Ash wrote.

"250bps in hikes when the market was expecting 350-500bps just is not enough."

While the move "marks the second step in the abandonment of an ultra-loose monetary policy," the 650 basis point rate hike in June disappointed markets that had "hoped for shock therapy after a post-election overhaul in Erdogan's economic team," said Bartosz Sawicki, a market analyst at Conotoxia Fintech.

"Similarly, today's decision comes in below the majority of market forecasts. As a consequence doubts prevail whether a gradual tightening is enough to restore credibility and re-establish price stability after years of pursuing unorthodox policies."

Despite the dollar to lira rate soaring in the time since Erdogan's reelection in May, "the central bank is unfazed by the most recent slide of the lira," he added, judging from its lower-than expected rate rise.

The bank's data showed an improvement in foreign exchange reserves and balance of payments. Recent trade and investment agreements with Gulf countries like the United Arab Emirates and Saudi Arabia will also boost parts of the Turkish economy. Still, those don't ensure macroeconomic stability if not enough is being done to tighten policy and rescue the lira, observers say.

"Peak rates of 25-30% this year still just about looks on track, but there are now clearer risks that the policy shift falls short and that the lira comes under much larger downward pressure," Liam Peach, a senior emerging markets economist at London-based Capital Economics wrote in a note.

"If monetary tightening continues to underwhelm, the lira is likely to pay the price," he said. "We expect it to fall another 10%, to 30 [to the dollar] by year-end, but the risks are skewed to larger and more disorderly falls."