Türkiye Pursues Policy Shift With Large Rate Hike but Hefty Inflation Challenges Remain

The 750bp rise in the Central Bank of the Republic of Türkiyes one-week repo rate to 25%, the biggest rise since 2018 and its highest level since 2004, makes the start of disinflation next year more likely. It also demonstrates the determination of the monetary policy committee under Governor Hafize Gaye Erkan to progressively adopt more conventional policies after decisions at its June and July meetings fell short of market expectations.

Interest Rates Deeply Negative

Still, real interest rates remain deeply negative as year-on-year inflation rose by almost 10pps in July to 47.8%. It is running nearly 10 times the 5% medium-term target. The central bank expects year-end inflation to peak at 62%. Headline and core inflation are both on the rise (Figure 1) and this trend may continue as the depreciation of the lira (about 30% year-to-date against the dollar) feeds through to domestic prices.

Fully restoring the credibility, independence, and effectiveness of the Turkish central bank will require additional rate hikes to reverse the current trajectory of inflation. Scope Ratings now forecasts the year-end policy rate at 33% and inflation above 60%.

Yet, the challenge is particularly acute compared with previous disinflation episodes following years of unconventional policies, which created financial distortions and altered monetary transmission channels. For instance, between 2018 and 2019, it took more than a year for the central bank to bring inflation down by 17pps to 10% (Figure 1) after raising its one-week repo rate by 1600bp.

The ability of the central bank to sustain monetary policy tightening over the near to medium term is decisive for Türkiye‘s inflation outlook and rating trajectory. On August 4, Scope affirmed Türkiye’s long-term foreign-currency ratings at B- and maintained a Negative Outlook.