Baffling Interest Rate Surge: Unraveling Turkey’s Surprising Central Bank Decision

On Thursday, the Central Bank of Turkey implemented a significant increase in its key interest rate, raising it from 25% to 30%. This 500-basis point adjustment comes as part of Ankara’s ongoing efforts to combat persistently high inflation rates.

In response to this development, the Turkish lira experienced a slight depreciation against the US dollar, reaching a rate of 27.06 at 2 p.m. in Istanbul, with the dollar strengthening by 0.3% against the local currency.

The central bank’s decision follows a series of interest rate hikes that have posed challenges for Turkish citizens. These measures are aimed at reversing several years of soaring inflation and a severely weakened currency, primarily attributable to the government’s persistent loose monetary policy.

Year-to-date, the lira has depreciated by 30% against the US dollar and has lost a substantial 78% of its value against the greenback over the past five years.

In June, Turkey raised its key interest rate for the first time in more than two years after President Recep Tayyip Erdogan appointed policymakers committed to implementing orthodox economic measures to combat inflation. Traditional economic wisdom dictates that raising interest rates is essential to curbing inflation. However, Erdogan, a vocal critic of interest rates, advocated for lowering them instead.

The country gradually reduced its policy rate from 19% in late 2021 to 8.5% by March, even as inflation soared, peaking at over 80% in late 2022 before moderating to just under 40% by June. Subsequently, the central bank embarked on a series of interest rate hikes, expressing its aim to bring inflation down to 5% in the medium term. However, Turkey’s annual inflation rate climbed to nearly 59% in August. The government now anticipates that annual inflation will reach 65% by the end of 2023, a stark increase from the previous year’s forecast of 24.9%.

Economic analysts responded positively to the recent interest rate hike in Turkey. Liam Peach, a senior emerging markets economist at Capital Economics in London, lauded the move as a sign of policymakers’ commitment to addressing inflation seriously. He noted that the central bank is now taking the measures many investors had hoped for, including significant interest rate hikes, in their efforts to combat inflation.

Timothy Ash, an emerging markets sovereign strategist at BlueBay Asset Management, acknowledged the importance of the rate hike but pointed out that real interest rates remain significantly negative due to high inflation levels. Ash emphasized the need for further tightening measures to address this issue.

This decision follows a substantial interest rate increase in August, which saw rates rise from 17% to 25%, surprising the markets. It signifies a continued commitment to this path, with expectations of rates reaching at least 35% by the end of the year, according to Capital Economics.

Ash also mentioned that Turkish Finance Minister Mehmet Simsek and his team argue that a combination of fiscal restraint, macro-prudential measures, and rate hikes will lead to a reduction in inflation and make holding the lira more attractive. However, he cautioned that this endeavor is a formidable challenge.