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As expected, the Central Bank of Turkey (CBT) kept its benchmark interest rates on hold on December 17. The regulator, which said it will maintain cautious monetary policy until the outlook for inflation falls in line with its medium-term targets, really had little choice.

The CBT kept its main policy instrument - the one-week repo rate - at 4.5%, the borrowing rate at 3.5%, and the overnight lending rate at 7.75%, it said in a statement released following its monthly monetary policy committee meeting. The central bank also left the rate for primary dealers' overnight borrowing unchanged at 6.75%.

"No real surprise given that inflation remains elevated and future trends are still uncertain," commented Tim Ash of Standard Bank. "While uncertainty remains over Fed tapering and its impact on [emerging markets], the lira has continued with a selling bias. The [currency] has not been helped by new found political risks, given the recent high level arrests ... which may be linked to clashes between the Gulen movement and the ruling AKP."

Capital Economics points out that the CBT has few options but to hold the line, as its hemmed into a corner. With interbank rates already nearing the overnight lending rate, which forms the ceiling for market interest rates, there's little more the central bank can now do to tighten monetary conditions without raising interest rates, the analysts note. However, the central bank is under strong political pressure to keep rates suppressed ahead of a busy election cycle over the next 18 months.

"In this regard, much will hinge on the financial market reaction to [the December 18] FOMC meeting, at which it looks like the Fed will start to taper its asset purchases," writes William Jackson at the London-based research company. "This reaction to 'tapering' is highly uncertain. But the bigger picture is that Turkey is one of the most vulnerable emerging markets to tighter global monetary conditions due to its large current account deficit (at 7.5% of GDP) and excessive reliance on portfolio capital inflows."

"All told, we think the lira will come under renewed pressure over the next 12 months, perhaps weakening to 2.20/US$ by end-2014 from its current level of 2.04/US$," he concludes. "Concerns about currency weakness may force the central bank to raise the O/N lending rate in order to shore up capital inflows. We have pencilled in 50bp of hikes next year (to 8.25%)."