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Turkey Central Bank Raises Rates to 24%, Lira Surges Above 5%

International investors broadly welcomed the rise in interest rates, but remain concerned about the ongoing diplomatic tensions between Ankara and Washington
The lira recovered some lost ground once the central bank bowed to conventional economic wisdom,  in contrast to when it held rates steady in July.The lira recovered some lost ground once the central bank bowed to conventional economic wisdom,  in contrast to when it held rates steady in July.

The Turkish central bank caught international markets by surprise Thursday as it aggressively hiked interest rates in an effort to strengthen consumer confidence, stem inflation and rein in the currency crisis.

Interest rates were increased to 24% from 17.75%, which is more than double the median of investor predictions of a 3% hike. The Turkish lira surged above 5% in response, firming to around 6.1 against the dollar, news outlets reported.

This time, however, the lira made back its lost ground once the central bank bowed to conventional economic wisdom, in contrast to when it held rates steady in July.

International investors broadly welcomed the move. "TCMB (Turkish Republic Central Bank) did show resolve in hiking the one-week repo rate substantially and going back to orthodoxy," chief economist Inan Demir of Nomura International said.

The central bank had drawn sharp criticism for failing to substantially raise interest rates to rein in double-digit inflation and an ailing currency. The lira has fallen by more than 40% this year.

The rate hike is an apparent rebuke to Turkish President Recep Tayyip Erdogan, who has been opposed to such a move.

Only hours before the central bank decision, Erdogan again voiced his opposition to increasing interest rates. The Turkish president reiterated his stance of challenging orthodox economic thinking, arguing that inflation is caused by high rates, although that runs contrary to conventional economic theory. Erdogan also issued a presidential decree banning all businesses and leasing and rental agreements from using foreign currency denominations, VoA reported.

The central bank indicated further rate hikes could be in the offing. "Tight stance monetary policy will be maintained decisively until inflation outlook displays a significant improvement," the central bank statement reads.

The strong commitment to challenge inflation was welcomed by investors. "Most importantly, the CBT seemed to be vocal about price stability risks," wrote chief economist Muhammet Mercan of ING bank.

Crazy Spending

Fueled by August's sharp fall in the lira, which drove up import costs, inflation is on a rapid upward trajectory. Some predictions warn inflation could approach 30% in the coming months.

While international markets are broadly welcoming the central bank's interest rate hike, economist Demir warns more action is needed. "This rate hike does not undo the damage inflicted on corporate balance sheets, and market concerns about geopolitics will remain in place. So this is not the hike to end all problems," he said.

The World Bank and IMF repeatedly have called on Ankara to rein in spending, which they say is fueling inflation. Perhaps in response, Erdogan has announced a freeze on new state construction projects.

In the past few years, he has embarked on an unprecedented construction boom, including building one of the world's largest airports and a multibillion-dollar canal project in Istanbul, which the president himself described as "crazy".

A Test of Independence

Erdogan has reproached the central bank for sharply raising interest rates, saying the country would "see the results" of the bank's independence.

Addressing his ruling party's officials Friday, Erdogan said: "Here you go, have your independence. We will see the results of the independence." He said that his "patience" with the bank would have its limits.

He repeated a claim that Turkey's currency woes were part of a foreign conspiracy put into motion because Turkey did not "respond" to US demands. Washington is pressing Turkey to release a detained American pastor. Andrew Brunson is charged with terror offenses by a Turkish court.

Turkey, meanwhile, is frustrated by the refusal of the US to extradite a Pennsylvania-based Muslim cleric Fethullah Gulen accused by Turkish authorities of engineering a 2016 coup attempt in Turkey.

Brunson's detention saw US President Donald Trump impose trade tariffs on Turkey, which triggered August's collapse in the lira. Trump has warned of further sanctions.

Investors also remain concerned about ongoing diplomatic tensions between Ankara and Washington.

The Right Decision

"This was the right decision," commented Timothy Ash, senior emerging markets strategist at Bluebay Asset Management. "The Turks just gave themselves a chance—to hold the lira, and rebuild the trust of the market. They can get out of this without the IMF and without resort to capital controls," CNBC reported.

"The rebalancing will be brutal, but with the right policies herein, there is now a way out."

American economist Adam Posen called the decision "the most hopeful thing for some time," expressing relief that Turkey's central bank "had the guts" to hike rates in what was seen as defiance against Erdogan. Just ahead of the decision, he had accused the Turkish president of "bringing on chaos in Turkey's economy".

While a positive start, the currency faces a slew of challenges ahead, experts agree.

"The lira will remain under pressure in the coming months owing to tightening global liquidity conditions and tensions between Turkey and the US," said Agathe Demarais, Turkey analyst at the Economist Intelligence Unit.

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