Turkish interest rates set to rise in quest to soothe markets

Kyodo via Reuters Connect

• Inflation in Turkey sits at 39.6%, down from a peak of 85.5%
• New central bank governor expected to increase interest rates
• Lira has fallen 16% against the dollar since Erdoğan’s May poll victory

Turkish policymakers are likely to raise interest rates on Thursday at their first meeting since veteran leader Recep Tayyip Erdoğan was re-elected as president.

The hike will help to ease inflation and support the ailing lira but could cause banks major headaches.

Following Erdoğan’s surprise electoral triumph on May 28, he appointed Mehmet Şimşek as finance and treasury minister and Hafize Gaye Erkan as central bank governor.

The duo are market-friendly former bank industry executives and their hiring was seen as an attempt to quell fears over Erdoğan’s unconventional economic policies.

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The nominally independent central bank has essentially become part of Erdoğan’s government, analysts say, slashing interest rates in response to soaring inflation.

This strategy contradicts mainstream economic thinking that interest rates should rise to combat increasing prices and sent the lira tumbling.

Annual inflation has eased somewhat, declining to an 18-month low of 39.6 percent in May in a seventh straight monthly decrease since peaking at 85.5 percent last October, central bank data shows.

Yet economists attribute the slowing pace of price rises to a drop in imports following the lira’s slump and a fall in energy costs, rather than a vindication of Erdoğan’s actions.

Turkey’s one-week benchmark interest rate is 8.5 percent, down from 19 percent in 2021. Analysts expect that Erkan, the new central bank governor, will raise rates when she hosts her first policy committee meeting on June 22. Any increase would be the first since March 2021.

“A short-term pivot in monetary policy is likely,” Thomas Gillet, director of sovereign and public sector ratings at Scope Ratings, told a Tellimer webinar.

The committee will probably raise the Turkish benchmark interest rate to around 15 percent, said Arda Tunca, an independent Bodrum-based economist.

Such a hike should help to reduce annual inflation and provide some relief to the lira, although its broader impact on Turkey’s ailing financial sector will be limited without banking regulatory reforms, said Tunca.

The lira has fallen a further 16 percent versus the dollar since Erdoğan’s poll victory and overall has lost more than 90 percent of its value during the past decade.

“A rate increase alone isn’t enough to make foreigners think they can safely invest in Turkey again,” said Tunca.

Banking restrictions

The banking regulator introduced a series of rules that constrain banks’ freedom to make commercial lending decisions. For example, lenders must buy government bonds against the loans they sell. Rising interest rates will make these bonds fall in price, causing banks significant paper losses.

“This short-term pivot on monetary policy would require fine-tuning because of the downside pressure on corporate and bank balance sheets,” said Scope’s Gillet, noting these strains will test the banking system’s resilience.

Turkey returns to the polls in March 2024 for local elections in which Erdoğan’s ruling AK Party will seek to retake control of the country’s four biggest cities. After that, many experts expect the veteran ruler to resume his unorthodox economic policies. Such a prospect will deter foreign investors.

“There is no properly functioning market economy in Turkey,” added Tunca. “Policymakers will have to be very careful and act slowly throughout the delicate correction process.”