Turkish Central Bank Surprises with Interest Rate Hike

Economics News: In a significant policy correction, Turkey’s Central Bank raised interest rates to 15% on Thursday, marking the first increase since 2021. The move, led by the country’s new economic leaders, falls short of more aggressive actions urged by some investors and economists to combat inflation.

Turkey’s central bank has raised the one-week repo rate, the country’s benchmark interest rate, from 8.5% to 15%, reversing the low rate set by the previous central bank governor.

Despite signaling a new direction, the decision is likely to disappoint investors and economists who advocated for interest rates to surpass the country’s current inflation rate of 39%.

Following the announcement, the Turkish lira depreciated more than 4% against the U.S. dollar. The decision fell well below predictions made by major banks and analysts, some of whom anticipated Turkey doubling, tripling, or even quadrupling interest rates on Thursday. Consequently, investors sold Turkey’s foreign bonds, leading to higher yields.

Selva Demiralp, a former economist at the Federal Reserve Board and now a professor at Istanbul’s Koc University, expressed concerns about the decision, stating that it fails to control inflation expectations and will sustain pressures on the Turkish lira.

This decision comes after President Recep Tayyip Erdogan replaced his finance minister and the head of the central bank, responding to a cost-of-living crisis that impacted his support during a contentious re-election campaign in May.

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Contrary to conventional central bank practices worldwide, Erdogan had previously pressured the bank to reduce interest rates, disregarding the country’s high inflation rate. He believed that lower rates would stimulate economic growth and eventually bring down inflation, a view disputed by economists throughout history.

Erdogan’s credit-driven growth strategy has created imbalances in the economy, prompting him to implement a complex web of regulations and financial programs to mitigate the situation. However, these measures have led to a dangerous depletion of foreign currency reserves and adversely affected the living standards of millions of Turkish people.

This decision, the first made by the new central bank governor Hafize Gaye Erkan, indicates a potential return to orthodox economic policies. Earlier in June, Erdogan appointed Erkan, a Princeton-trained expert in financial risk management and a former executive at First Republic Bank and Goldman Sachs Group.

To instill confidence in investors who have withdrawn their funds from Turkey in recent years, Erdogan also reinstated Finance Minister Mehmet Simsek, a longtime ally who returned to the government in June after a five-year hiatus.

Before the decision, both Erkan and Simsek provided few policy specifics after their appointments, leaving Western banks and analysts uncertain about their stance on interest rates. Consequently, some had raised hopes for a more assertive approach to tackling inflation on Thursday.

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However, the decision has left market players with questions and has been deemed insufficient in controlling inflation by Turkish economist Ugur Gurses.

Nonetheless, some investors and analysts perceive this decision as a gradual return to orthodox economic policies by Simsek and Erkan, suggesting the possibility of further interest rate hikes throughout the year.

The central bank has signaled that it intends to continue tightening monetary policy until it achieves a significant improvement in the inflation outlook. Turkey currently faces a precarious financial situation, characterized by Erdogan’s unorthodox economic vision, which involved reducing interest rates while injecting billions of dollars to stabilize the plummeting Turkish lira.

This approach has resulted in rampant inflation, driving up the costs of essential goods and services and placing immense strain on the country’s finances. Turkey is grappling with a severe shortage of foreign currency, and a significant portion of its reserves is borrowed.