Turkey’s central bank delivers massive interest rate cut

Turkey‘s central bank delivered a massive interest rate cut Thursday in a bid to jump-start the country’s recession-hit economy.

Policymakers – including newly installed central bank chief Murat Uysal – slashed Turkey’s key interest rate from 24 percent to 19.75 percent.

The rate cut was bigger than most analysts had expected, and marked a dramatic step back from an emergency monetary policy stance adopted during last year’s currency crisis, when a collapse in the Turkish lira pushed inflation above 25 percent, prompting aggressive rate hikes.

Inflation has since dropped to below 16 percent, leaving Turkey with the highest real interest rate adjusted for inflation in any emerging market. This has opened the door for policymakers to lower borrowing costs for the first time in four and a half years in the Middle East’s largest economy.

The central bank cited improving inflation for its Thursday decision and said its stance remained cautious even after it delivered the biggest rate cut since at least 2003.

“Maintaining a sustained disinflation process is the key for achieving lower sovereign risk, lower long-term interest rates, and stronger economic recovery,” the Turkish government said in a statement. “Keeping the disinflation process in track with the targeted path requires the continuation of a cautious monetary stance.”

The lira, which has been volatile this year after a nearly 30 percent drop in 2018, tumbled immediately after the policy announcement. But it quickly bounced back and stood at 5.68 against the United States dollar.

The lira has steadied in recent weeks, even though Turkey faces the threat of US sanctions over its purchase of Russian S-400 missile systems. The lira’s stability, along with a recent dovish shift among the world’s major central banks, also paved the way for the easing.

The credibility of Turkey’s central bank has been questioned by investors, most recently this month after Turkish President Recep Tayyib Erdogan sacked central bank chief Murat Cetinkaya, saying he had failed to follow the government’s policy instructions.

Reuters news agency, citing sources, later reported the president dismissed Cetinkaya a year before his term ended because he resisted requests for a 300-basis-point cut, which prompted some analysts to predict an even sharper easing on Thursday.

A Reuters poll before Uysal took over from Cetinkaya found economists expected only a 100-basis-point cut.

Any further cuts could put the lira “under substantial depreciation pressures (in part) given markets’ concerns about the central bank’s ability to tighten when needed,” said Ugras Ulku, a former economist at Turkey’s Treasury who is now head of EM Europe research at the Institute of International Finance.

Political pressure

Lower borrowing costs could help lift Turkey’s economy out of recession, reduce its 13 percent unemployment rate, and bring relief to borrowers whose real interest rates, when adjusted for inflation, were roughly halved to four percent on Thursday. But that is still higher than the average for emerging markets.

Inflation dropped markedly last month to its lowest level in a year, sealing expectations for Thursday’s rate cut. The bank said inflation “displayed a significant fall” in the second quarter.

Turkey’s $766bn economy began contracting last year after the currency crisis was sparked by a convergence of factors including a diplomatic spat with the US, a build-up of cheap foreign debt, and worries over the central bank’s independence from Erdogan.

A sharp drop since then in the current account deficit – and the broader shift by the US Federal Reserve and European Central Bank to a more accommodative stance – have helped stabilize the lira, which earlier this year briefly sold off again.

But the new rift with Washington over the purchase of S-400s has set the stage for sanctions that could again rattle the currency, prolong the recession, and scuttle the central bank’s plans for more rate cuts.

“Even though I was surprised by the size of the cut, it is still quite reasonable given the current global market environment, and more cuts are coming,” said Marek Drimal, London-based EMEA strategist at Societe Generale.

Erdogan, who suffered stinging local election setbacks this year due in part to his handling of the economy, holds the unorthodox monetary theory that higher interest rates spark inflation, rather than rein it in.

Uysal, who has been one of the bank’s more dovish policymakers by leaning toward lower interest rates, said shortly after taking the reins that “there is room for maneuver in monetary policy”.

Former governor Cetinkaya hiked rates by 625 basis points in September in a move that many investors saw as coming too late. Still, it helped stem further losses in the lira and put a lid on inflation, even while it helped push the economy into recession.

After Cetinkaya’s dismissal early on a Saturday morning this month, the three major ratings agencies warned about political interference, and Fitch cut Turkey’s sovereign rating further into junk territory.

“Everything seems to come from the monetary easing playbook of Mr. Erdogan,” said Cristian Maggio, head of EM strategy at TD Securities. “I don’t see anything else striking other than the magnitude.”