Turkey’s rate decision will be a litmus test for central bank independence from Erdogan

Tuesday’s monetary policy meeting will be a litmus test for the independence of the Central Bank of the Republic of Turkey, which has had to balance the country’s sky-rocketing inflation and ailing currency with President Recep Tayyip Erdogan’s view that higher interest rates are bad for the economy.

The reason why the CBRT should raise its benchmark rate on Tuesday seems straightforward to some analysts, after consumer price inflation leaped to 15.5% year on year in June, outpacing both consensus forecasts and the previous month’s figure. Since the last rate hike on June 7, the lira has also fallen some 6%, fueling inflation further.

Since April, Turkey’s central bank has raised interest rates three times to counteract high inflation and a slump in the lira USDTRY, -0.8617% Since June, the central bank also operates in a simplified framework in which the one-week repo rate is its key policy rate. It currently stands at 17.75%.

But Erdogan, who maintained the presidency after a snap election in June, is staunchly against higher interest rates. His vision for Turkey’s economy seems to be growth through policy stimulus, said ABN Amro emerging market economist Nora Neuteboom.

In Erdogan’s new term, he will have extended powers granted in a parliamentary referendum, and market participants wonder whether the days of an independent CBRT are numbered.

Erdogan has issued a decree that lifts the limit of the central bank governor’s terms. The decree also “gives the president de facto control of the appointment of the governor and deputy governors; hardly reassuring for anyone concerned about CBRT independence,” said TD Securities’ senior emerging markets strategist Paul Fage.

This move alone made investors buckle up for a turbulent ride full of unorthodox policy choices, Neuteboom added.

“Given the tight grip of Erdogan on the central bank and as higher interest rates do not fit with Turkey’s economic growth strategy, we expect the Turkish central bank to keep the one-week repo rate on hold,” she wrote in a note Monday.

At the same time, “if the CBRT does not hike rates tomorrow, the markets will take this as a clear sign of political interference and dollar-lira will move sharply higher,” Fage said. “We would expect dollar-lira to move about 1% lower if the CBRT hikes by 100 basis points, and to move about 3% higher if they keep rates on hold,” he added.

Even with the rate hikes, the lira is down more than 20% since those hikes—typically a boon to the home currency—began in April, according to FactSet. One dollar last bought 4.7540 lira on Monday, down 0.8% on the day, according to FactSet.

But the weaker currency may also be an opportunity.

“The lira remains the highest-yielding core emerging markets currency, and the market is already priced for its inherent risk,” said Alessio de Longis, portfolio manager and macro strategist at OppenheimerFunds. “The reality is that the lira is becoming very cheap and it’s expensive to short it.”

From a price-versus-yield point of view alone, the lira might just attract some more interest with the goal of harvesting the high carry, irrespective of its political and economic future in the longer term. In a carry trade, investors buy a foreign currency to either benefit from higher overnight interest rates or purchase higher yielding local assets.

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