Turkish lira in pause mode until after election

Following the bloodbath created by the slide in the Turkish lira last month, the situation in Turkey seems to have settled down thanks to the central bank’s 300 basis-point rate hike and its decision to employ a more “simplified” version of its unorthodox monetary policy.

Returning to its former operations manual, the bank announced that the one-week repo rate would become the policy rate, fixed at 16.5 percent, with the overnight borrowing and lending rates ranging +/- 150 basis points from that level, setting a so-called interest-rate corridor.

Such a monetary policy band will of course permit the bank to hike rates without the need for a meeting or announcement, and pull up the policy rate to 18 percent if need be.

Turkey interest rates

A visit to London by Deputy Prime Minister Mehmet Şimşek and Central Bank Governor Murat Çetinkaya this week is aimed at winning back the hearts of investors. President Recep Tayyip Erdoğan’s shocking interview with Bloomberg earlier in May had sent the lira into freefall, prompting the central bank intervention. The visit appears to have helped to stabilize the lira.

With the central bank’s measures already taken, the duo had a tangible story to tell uneasy investors as they sought to prove the central bank’s autonomy and future monetary policy rationality.

The central bank’s move could be taken as a victory of orthodoxy over the highly unorthodox, adventurous economic policies of Erdogan’s advisers at the presidential palace. Time will tell whether this rationality will persist.

Turkish inflation

Thus, in just a week, the lira strengthened to 4.48 per dollar from its record low of 4.92 against the U.S. currency. The gain was also fueled by easing in U.S. 10-year bond yields to 2.80 percent from above 3.0 percent levels, and the dollar weakening against a basket of other major currencies amid mixed signals about the U.S. economy.

 Yet, make no mistake, U.S. 10-year bond yields are set to reach 3.5 percent by the end of this year and, in a similar manner, the dollar index will gain ground again as the European Union is shaken by Italy’s ailing banks, Japan struggles with low inflation and emerging markets remain under the spotlight for their foreign debt-related weaknesses. Thus, volatility and further losses will come back to haunt emerging-market currencies in the months ahead.

What we can deduct from the Şimşek-Çetinkaya London trip is that Turkey is promising to refrain from any more fist-fighting with financial markets. Turkish policymakers have basically pledged further rate hikes when the U.S. Federal Reserve raises its own policy rate another notch, or tension in emerging markets increases again. Thus, we can be sure that the funding rate will increase to 18 percent in the weeks ahead, which will please investors who are demanding higher returns for Turkey’s higher risks.

However, Şimşek has also promised further rebalancing of the economy in Turkey, starting with inflation and the current account deficit. These pledges of course require Erdoğan’s approval and that he drops his insistence on high growth rates. We have yet to hear from him on this.  

Turkish inflation expectations

Talking about inflation, next week May inflation data will be published by the statistics agency. Core and headline consumer price inflation (CPI) figures were already set to end the year in double-digits prior to the lira’s record slump in May. Now that the lira is expected to stabilise at around 4.5 per dollar, end-of-year inflation is set to reach 13-15 percent, peaking in the summer months.

Thus, the central bank’s main funding rate, now fixed at 16.5 percent versus 14-15 percent CPI inflation, will not work effectively in reversing the lira’s extreme losses beyond current levels of 4.4-4.6 against the dollar. Nor does central bank policy mean a fully-fledged fight against Turkey’s very high inflation rate. As levels of core inflation level turn sticky around 12-13 percent, the market will soon ask the central bank to get “really serious” on inflation, as was allegedly promised in London early this week. Pulling the policy rate to the upper band of the interest corridor might be the central bank’s initial reaction to keep investors at bay; yet it would necessitate more on the fiscal front after the elections to really get back to single-digit inflation; not to mention the 5 percent target range.

The 300-basis points rate hike, the central bank’s simplification in monetary policy and President Erdoğan taking a back seat when it comes to monetary policy summarises the approach of the government as the June 24 election nears. This will mean predictability for investors and will help prevent further negative volatility in the value of the lira.

The problematic issue going forward is of course Erdoğan’s insistence on ensuring the economy grows above 5 percent this year and his accompanying fiscal policies to support such a target. As the President believes that lira weakness is temporary due to global market volatility, he seems to prefer to remain mute for the time being. Yet, the monetary policy orthodoxy, represented by Şimşek and Prime Minister Binali Yildirim, and Erdoğan’s group of unorthodox economic advisors at the palace are still far from agreeing common ground for the future of Turkey’s economic management. On regular days, palace advisors have Erdoğan’s ear and the potential is therefore there for further lira volatility. For the time being, Şimşek and his peers appear to merely be firefighters who step in when the situation really gets out of hand, as they have done over the past week or so.

The situation therefore remains fluid and wrought with danger and potential instability following the June 24 election.