ISTANBUL — While markets reacted positively to Turkey’s central bank when it held interest rates steady last week, the decisions that Gov. Sahap Kavcioglu must make in future months will be harder and fraught with more risk for the embattled lira.
Higher inflation has eroded the margin of safety built in to interest rates by Kavcioglu’s predecessor at the bank, just as Turkey’s President Recep Tayyip Erdogan has stepped up his pressure for rate cuts. Kavcioglu — and investors — are acutely aware that Erdogan has sacked three successive governors.
Against that backdrop, the central bank’s resolve was notable. It promised on Thursday to hold the policy rate “at a level above inflation to maintain a strong disinflationary effect until strong indicators point to a permanent fall in inflation,” sending the Turkish lira up more than 1% against the U.S. dollar and adding 2.4% to the domestic stock market.
“Some investors appear to have breathed a sigh of relief that the president didn’t get his way,” wrote Jason Tuvey, senior emerging markets economist at Capital Economics, after the decision.
The bank’s promise may get harder to keep from here, since the consumer price index in July was 18.95% higher than a year ago, barely below the official interest rate of 19%. The weak lira has been a persistent source of inflation. The prices of oil and other commodities have risen sharply. Food prices have soared. It will not be until November that last year’s big uptick in prices drops out of the annual number.
The weak lira has been a persistent source of inflation, sending the price of food soaring. © AFP/Jiji
“Every time the president speaks about cutting rates, the lira depreciates … further complicating the central bank’s job,” said Ugur Gurses, an economist and former central banker.
Kavcioglu, a dovish academic and former member of parliament from Erdogan’s party, was appointed in March, becoming the fourth governor of the Central Bank of the Republic of Turkey (CBRT) since 2019. His predecessor Naci Agbal had attempted to shield the currency by hiking rates to 3% above inflation — one of the highest real interest rates in emerging markets — and his sacking hit the lira hard.
The resumption of pressure from Erdogan comes as the president’s approval ratings tumble to some of the worst of his career, dragged lower by public anger over food prices and broadly defined unemployment rate that hovers around 22%.
“From here I am giving my signal to certain places, because from now on it’s not possible for inflation to go higher,” Erdogan said during a TV interview aired on Aug. 4. “Hence we will see a drop in interest rates.”
Some wondered if the “signal” was meant as much for government statisticians as for the central bank. There are already suspicions over the quality of data from government-run Turkstat. Erdogan has sacked four Turkstat chairmen since 2019.
“On inflation, all I can say is it seems unlikely inflation will peak below 19%, but I’m not sure how much faith I now have in the inflation numbers,” said Timothy Ash, senior emerging markets sovereign strategist at Blue Bay Asset Management, in comments to Nikkei Asia.
Piotr Matys, senior foreign exchange analyst at InTouch Capital Markets, said that “even a relatively measured policy rate cut in September to appease Erdogan would leave the Turkish lira more exposed and vulnerable against the dollar,” since it could coincide with tightening monetary policy in the U.S.
U.S. Federal Reserve Chairman Jerome Powell is due to set the outlook for U.S. rates in a speech to the Jackson Hole conference later this month, Matys pointed out, and a more hawkish stance could strengthen the dollar.
The CBRT has worked to put more protections around the Turkish currency. After it blew $130 billion of forex reserves trying to prop up the lira over a two-year span until last November, before Agbal’s tenure, the CBRT under Kavcioglu has expanded access to foreign currency through swap agreements with foreign central banks. These have included an extra $3.6 billion with China and, last week, $2 billion with South Korea. Excluding swaps, net forex reserves remain deeply negative, however: minus $41 billion at the end of July.
Erik Meyersson, senior economist at Handelsbanken Capital Markets, said this remains a critical problem. “Swap agreements with other central banks are just stopgap measures,” he said.
Economists have been rethinking how soon and how far Kavcioglu can safely cut rates in the face of high inflation. Deutsche Bank economists moved their forecast for the first cut to November from October and predicted just a 100 basis point reduction by the end of the year, compared with a previous forecast of 200 points.
“If the central bank falls for the green ‘signal’ of Erdogan at the most critical juncture for inflation, we will experience a huge accident,” Gurses said. “Due to repeated mistakes, Turkey already fell into an inflation/currency devaluation spiral. We risk inflation soaring into the 20s, 30s per cent.”
Matys added that since “the real interest rate is barely in positive territory, you could perfectly argue that given the underlying trend in inflation observed over the past months, the CBRT should have raised policy rate even further from 19%. But of course it is impossible after the dramatic reshuffles by Erdogan that we saw recently at the central bank.”
Turkey’s Central Bank headquarters in Ankara. © Reuters
Asked if the bank is feeling pressure from Erdogan, Kavcioglu deflected specifics. “Global inflation, commodity prices, supply chain problems create more pressure on us,” he said in a July media conference. “As a monetary policy committee, we take decisions totally evaluating data and developments in the markets and in the world.”
Yet the bank’s credibility remains an issue for financial markets and will likely be tested before the year is out. The CBRT last month raised its year-end inflation projection to 14.1% from 12.2%, suggesting it sees plenty of room to cut rates and keep its policy shield intact.
However, the most recent median expectation of economists, polled by data provider Foreks, is for year-end inflation of 18%. That suggests Kavcioglu has much less room for maneuver.