Turkish lira reverse losses as interest rates surge

Summary:

• Turkish central bank lifts its one-week repo rate more than expected

• The decision contradicts the latest Erdogan’s remarks

• Erdogan bans Turkish entities from conducting business in foreign currencies

It has been a tumultuous day for the Turkish currency so far. At first, Recep Erdogan suggested that rates should be lowered which sparked the huge downward move in the lira. A few hours later this move was erased altogether when the central bank defied Turkey’s president delivering a dramatic rate increase. The one-week repo rate was hiked to 24% from 17.75% well  above the median estimate of 21%. It quickly pushed the TRY higher from a 2% loss to almost a 4% gain. It its statement the central bank wrote that “recent developments regarding the inflation outlook point to significant risks to price stability”. Furthermore, the bank explicitly admitted that widespread price increases mirrored “the movements in exchange rates”. Taking into account a deterioration of price behaviour the bank wrote that it “continues to upside risks on the inflation outlook, despite weaker domestic demand conditions.” Is this a tremendous rate increase the last word from the central bank? Based on the statement one may suppose that the bank remains ready to act if necessary as it assured that it “will continue to use all available instruments in pursuit of the price stability objective”. The document concluded that tight monetary conditions will be maintained until “inflation outlook displays a significant improvement”.

The mighty rate increase is the second tool aimed at impeding runaway lira’s depreciation implemented today. Earlier Recep Erdogan effectively banned Turkey-based companies from conducting business in dollars and euros - this news helped the lira jump briefly. In a decree published by the local authorities it was written that the lira is the only legal currency for most contracts between Turkish entities for any kind of product or service. The decree also said that some agreements will be exempt from the new rules, these conditions will be specified by ministers later on. Has the outlook for really changed? The rate hike is a clear message from the central bank that it will no more tolerate double-digit inflation and dramatically falling currency, and if this policy change is sustained, it could be undoubtedly TRY supportive. However, given that fact that Erdogan is unlikely to change his mind regarding a relationship between interest rates and inflation one may suppose that he will continue expressing his stance which would weigh on the lira again.