Turkish rate cut baffles markets as inflation heads for double figures

The Central Bank of the Republic of Turkey (CBRT) today took markets by surprise, cutting its policy interest rate from 10% to 9.5%, but saying its monetary policy stance "will continue to be tight… until there is a significant improvement in the inflation outlook".

The central bank's claim that the rate cut leaves policy "tight" fits with the interpretation of a sharp rate hike in January this year having been a "front-loaded" move, as CBRT deputy governor Turalay Kenç described it in an interview with CentralBanking.com last week.

Nevertheless, the decision to cut today looks baffling in the context of inflation heading towards double the target rate of 5% per annum. In the year to April 2014 the consumer price index grew by 9.38%, continuing a consistent upward trend since March 2013 when inflation bottomed out at 6.13%. The last time annual inflation came in below the 5% target was three years ago, in April 2011.

What is more, Kenç last week said the CBRT must now regain its focus on targeting price stability having been diverted in recent years by questions of financial stability and capital account management.

Maya Senussi, a Turkey analyst with Roubini Global Economics, said today's move was not warranted by the inflation outlook, but the CBRT's decision to leave the overnight lending rate unchanged does leave the bank with some flexibility to respond to any further depreciation in the lira.

"The strategy going forward should be no cuts," Senussi said, "but the odds of another cut in the coming months are high, providing the appetite for risky emerging market assets holds."

The rate cut was also likely motivated by a desire on the part of the central bank to stimulate growth, Senussi pointed out. Kenç said last week the CBRT was already bullish on growth, with a forecast of 4% for the coming year compared with most market forecasts of around 2.5% – despite macro-prudential measures imposed by the Banking Regulation and Supervision Agency, which Kenç said are "working quite effectively, and the slowdown in consumer loans has been quite visible".

The CBRT monetary policy committee statement today said: "Loan growth continues at reasonable levels in response to the tight monetary policy stance and macro-prudential measures. In line with these developments, recent data indicate to a modest course in private final domestic demand.

"Meanwhile, with the help of the recovery in foreign demand, the contribution of net exports to economic growth is expected to increase. The committee expects that such a demand composition will support disinflation and will lead to a significant improvement in the current account deficit in 2014."

Deputy governor: government comments on rates ‘quite normal'

In a wide-ranging interview with CentralBanking.com last week, Kenç said concerns over the central bank's independence from the Turkish government has never been seriously under threat, despite heightened scrutiny and concern internationally over the winter when domestic political instability combined with global financial turmoil to create a uniquely difficult period for the country and its central bank.

However, Kenç says, "in hindsight you would say that emerging market economies have withstood the financial turbulence arising from the Fed's first explicit talk of tapering", the Federal Reserve's reduction in the size of its monthly asset purchases, "thanks to prudent macroeconomic policies that emerging market economies have been implementing for many years; to their improved institutional frameworks, and thanks to the international reserves that they have accumulated."

Another key tool the central bank has in the fight against capital account volatility is a wide, asymmetric interest rate corridor. According to a recent paper published by the CBRT, the wider corridor "creates higher uncertainty about short-term yields and, in principle, discourages short-term portfolio inflows".

The CBRT has other tricks up its sleeve too. "When the tapering talk started in May 2013, we reacted by raising short rates by using liquidity policy rather than interest rate policy," Kenç says. "So in late August 2013, short rates in Turkey increased by around 300 basis points. So that was a significant rise in short rates, i.e. overnight rates."

The most eyebrow-raising move came in January this year, however, when an extraordinary meeting was called at which the overnight rate was raised by 425bp to 12%, and the one-week repo rate, which henceforth would become the main policy rate, was more than doubled, from 4.5% to 10%.

Kenç says this "strong and front-loaded" move was a response to "the deterioration in inflation outlook". Not only the deterioration in inflation outlook, but also quite acute political turmoil in Turkey at the end of last year, which led to volatility in our monetary and financial markets, and also the concerns raised over the independence of the central bank."

"Those three domestic events really contributed to volatility in the Turkish financial markets", he said, "and especially in the currency, and so in that time between mid-December and late February 2014, Turkey performed badly, in comparison to peer emerging market economies. But at the end of January, at the interim MPC meeting, we were very decisive and we provided a strong and front-loaded response to the heightened volatility in the Turkish financial markets."

Comments from prime minister Recep Tayyip Erdoğan on the desirable path of the policy rate around that time did not worry the Turkish central bank or ordinary Turkish citizens, according to Kenç. "The government and the prime minister do talk about monetary policy and the level of the interest rate," he said, but "this is something quite understood in Turkey". Nevertheless, "the central bank is an independent central bank and does what the economy requires. That is the basic understanding in Turkey."

In bad times such as the start of 2014, Kenç said, "you get different perception from the international community, international investors and the international press. Those quite common things for the Turkish public are no longer seen as normal things."