The biggest obstacle obstructing Turkey’s government in its attempts to lower inflation is its inability to persuade the public that price growth will slow, an economist said on June 5 as the country’s official inflation rate once again showed acceleration.

“They cannot make people believe that inflation will come down, which increases pricing as cautious people are trying to prepare for the storm ahead,” veteran Turkish economist and writer Mustafa Sonmez was reported as saying by AGBI.

Appointed after President Recep Tayyip Erdogan’s last election win in May 2023 – when Turkey’s leader of 23 years authorised a switch away from failing “Erdoganomics” that persisted with low interest rates despite roaring inflation – the country’s “orthodox” economic management officials, led by ex-Wall St banker Mehmet Simsek, has only managed to bring official inflation down from June 2023’s 38% to the latest reading of 33% with a disinflation campaign focused on reducing demand.

“This shows that narrowing demand is not sufficient and you have a supply problem, especially with food staying at 35 percent and housing costs at 45 percent, which clearly shows they cannot bring it down,” Sonmez was further cited as saying.

In weighing up why Turkish inflation is again on the rise, the impact of the US-Israeli war with Iran and the Iranian blockading of the Strait of Hormuz energy export chokepoint has to be taken into account, given Turkey is hugely dependent on imported oil and gas and vulnerable to high energy prices, but the country’s consumer price index growth has officially been around 32% or a little above for the past year – not just during the three months of the conflict.

Prior to the release of the May inflation figures, Simsek defended the disinflation programme, while pointing the finger at external difficulties, saying on social media: “We live in a shock-prone world and a tough neighbourhood. Shocks may slow the pace of the programme’s delivery, but they are unlikely to change the direction of travel.”

The Turkish lira (TRY) dropped to a record low of 46 to the dollar as the market digested the inflation data.

Bloomberg on June 5 reported that Algebris Investments was purchasing default protection on Turkish bonds, as it was seeing a higher probability of a credit event with the Iran war adding to strains on the economy.

Gabriele Foa, who manages €3.7bn ($4.3bn) for Algebris from Milan, told the news service that Turkey‘s economic situation was increasingly fragile, driven by a deteriorating current account deficit, climbing energy prices and low international reserves pushing up the risk of dollarisation.

“In credit and in fixed income in general, the value is extremely limited; you are not adequately compensated for what could happen in the next couple of years,” Foa was reported as saying, adding: “We believe it is time to sell Turkey rather than buy.”

Central bank data show an almost 40% fall in the value of foreign holdings of Turkey’s local-currency securities since prior to the Iran war, which ignited at the end of February.

Turkish lira bonds have handed investors a 3.2% loss this year against a 1.1% gain for emerging markets as a whole, while sovereign debt in dollars showed a 0.3% loss against an average gain of 1.5% for developing country debt, according to data compiled by Bloomberg.

Turkey’s gross FX reserves contracted by one third this year to $53bn on May 29, their lowest point since June 2021, according to central bank figures.

“Seeing a default in Turkey is very difficult, but it is not a country where you can rule out a default,” Foa was also quoted as saying.

“Reserves are low compared to local dollars, and local dollar deposits plus the stock of debt are also very high relative to reserves. So, there is a situation in which it could happen,” he concluded, also observing: “2024 and 2025 were the perfect environment for the Turkey trade, but Turkey has reached the limits of its economic programme and it is better to wait on the sidelines now.”

Turkey’s central bank took 900 basis points off its benchmark rate during the second half of last year before putting the brake on in January, since when it has held the policy ​rate steady at 37%. After the outbreak of the war, the regulator tightened liquidity conditions by pausing funding from the main policy rate and moving to the overnight rate of 40%.

The course of the war from here could make or break the economic outlook for the country’s brittle economy.

“Now that the oil price looks clearly set to remain high for longer, if the Turkish central bank does not signal willingness to hike rates and keep them high for longer, pressure on the lira is likely to mount,” said Tatha Ghose, senior EM economist at Commerzbank AG.

Added Ghose: “The likelihood of reserves dropping further because of daily FX management will increase, and the probability of a disorderly development in markets will rise, too.”

The central bank’s Monetary Policy Committee (MPC) will hold its fourth rate-setting meeting of the year on June 11.