The Turkish central bank’s decision to keep its main interest rates on hold on January 19 despite rising inflation, the depreciating lira and volatility in global markets, has once again raised questions about the CBRT’s independence and credibility. These questions will only become louder when Governor Erdem Basci’s term ends in mid April.

The Monetary Policy Committee (MPC) kept its main policy rate (one-week repo) at 7.5% for the 11^th straight month and maintained its overnight borrowing rate and lending rates at 7.25% and 10.75%, respectively.  

The market may have expected this inaction, but it was far from convinced by the bank’s reasoning: since the January 19 meeting the lira, one of the worst performing currencies last year, has slipped another 1.2%, remaining above the symbolic threshold of 3 to the dollar.

No guidance

In December, following the US Federal Reserve’s decision to raise its own rates, Turkey’s central bank said it could start to "simplify" its policy if volatility in global financial market disappeared.  But this has not been the case: volatility, on the contrary, has increased.

The bank currently uses a system of multiple interest rates and many analysts argue that it is now time for the bank to move towards a more orthodox monetary policy.

However, the statement released after the MPC meeting this week provided no guidance, gave no indication as to when the bank could act. It simply dropped the reference to policy simplification.

In December, the bank said: “Should the decline in volatility observed after the start of the global policy normalisation persist, monetary policy simplification steps would begin with the next meeting”.

And after this month’s meeting, the bank had only this to say: “The committee also assessed the heightened global volatility since the beginning of the year.”

Being transparent and predictable are vital features of any central bank’s policy. But in the Turkish case, the markets have been left wondering why the bank did not act, when it would take steps, also why policymakers still stick with an unorthodox policy. The bank has provided no clues, leaving investors in the dark.

“Policy simplification – if delivered in a prudent way – would have made the policy much more understandable and predictable. Hence, market participants will remain uneasy and discouraged as the process gets delayed,” commented Yarkin Cebeci at J.P. Morgan in a note. The bank’s decision on January 19 increases the chances that the CBRT keeps the status quo at least until Basci’s term ends in mid-April, says Cebeci.

It is still unknown who will replace Basci. Investors fear that the new bank leadership could be even more amenable to the government’s populist demands to support economic growth.

Many analysts believe a rate hike is long overdue and are now more and more concerned about political pressure on the central bank and the bank’s independence. President Recep Tayyip Erdogan – who wants to change the constitution in order to move Turkey towards an all-powerful executive presidential system – has made clear his preference for the bank to stimulate growth, last year equating high interest rate with treason.

GDP growth picked up to 4% year-on-year in the third quarter from 3.8% in the previous quarter. In the latest medium-economic programme, the government forecasts that GDP growth will accelerate to 4.5% this year from 4% in 2015.

But analysts and international financial institutions find the government’s estimates too optimistic. A recent survey by the central bank forecast that the economy would expand by 3.4% this year and 3.8% in 2017. The World Bank says the Turkish economy will grow by 3.5% this year versus an estimated 4.2% in 2015, warning about headwinds on several fronts. It cites lira depreciation, weakness in the business climate and Russian sanctions as potential downside risks to growth.

“Headwinds contribute to a cautious medium-term outlook. At the same time, the continuing need for large capital inflows is a concern, amid difficult global financing conditions, especially as the central bank’s net reserves are modest,” World Bank economists said in January.

Falling growth and the weakening lira will make the country’s external liabilities problem worse. Turkey’s foreign funding needs, according to the OECD, are projected to reach 25% of GDP in 2016, including the refinancing of external debt. Local brokerage house Deniz Invest says that the central bank’s net reserves were only $28.6bn as of January 8.

If the growth outlook deteriorates, the central bank is likely to come under pressure from politicians to cut rates to stimulate economic activity to create a “feel good” factor when/if the ruling Justice and Development Party (AKP) holds a referendum on a new constitution to give Erdogan more executive powers.

“The longer the MPC leaves rates unchanged, the more concerned investors are likely to be that monetary policy is being influenced by the government’s desire to keep interest rates low”, commented Capital Economics in an emailed note. “This will only exacerbate concerns about the CBRT’s credibility and put the lira under (further) pressure.”

Under pressure

The depreciation of the lira has also added to inflation worries. Consumer prices rose 8.81% year-on-year in December, with Turkey missing the inflation target for the fifth year in a row. The depreciation of the local currency against the dollar by more than 20% last year and an annual rise of 10.87% in food prices were the main factors behind the disappointing 2015 inflation figure.

Interestingly, politicians do not seem too worried about the lira and inflation. Deputy premier Mehmet Simsek admits that battling inflation will be this year’s main economic challenge, but he sees no reason for any significant drop in the Turkish lira, even though emerging markets face another year of painful adjustment. “We don't really see fundamental reasons why the lira should depreciate in a meaningful way in real terms, because there is political stability, there is growth. The only downside is risk appetite towards emerging markets”, Simsek told Reuters on January 18.

The government has also hardly helped the fight against inflation: the recently announced hike in the minimum wage and rises in some administered prices will drive inflation upwards.

“The increase in the minimum wage and pensions will make a certain contribution to growth in 2016. However, we don’t see a serious increase in domestic demand.” Development Minister Cevdet Yilmaz said in an interview with Bloomberg, apparently downplaying the risks from the minimum wage hike on inflation.

The government has already revised its inflation expectation up from 6.5% to 7.5% for 2016 in the new medium-term programme.  

The central bank has become more concerned about the wage hike and other costs, with the MPC statement declaring “future monetary policy decisions will be conditional on the inflation outlook”. The impact of the wage hike on inflation is expected to be between 1.1-2.2 percentage points, while the central bank calculates that the recent hikes in administered prices will add 0.7 percentage points to inflation.

Analysts believe it is only a matter of time before the central bank is forced to tighten its monetary policy, but the delay could be very damaging.

“Ultimately, with inflation set to jump, we think the MPC will need to raise interest rates if it is to preserve its credibility in the markets and avoid a sharp lira sell-off”, says Capital Economics.

Tim Ash of Nomura, who is otherwise bullish on Turkey, warned ahead of the MPC meeting: “The danger is if they don’t do this [normalisation and tightening] now, they are forced to tighten much more painfully further down the line (a repeat of early 2014) – with much higher policy rate hikes then required now.”