Turkey set to raise interest rate to 20-year high in dramatic policy reversal

Turkey’s central bank is expected to announce a substantial increase in its key interest rate, reaching a 20-year high. This move follows President Recep Tayyip Erdogan’s surprising reversal of his unorthodox economic stance, a change that came after a challenging re-election in May.

The Turkish economy had been grappling with its worst crisis in decades, which most analysts attributed to Erdogan’s unconventional belief that high interest rates led to inflation. Erdogan had long criticized high interest rates, referring to them as “the mother and father of all evil,” and had consistently pressured the central bank to lower borrowing costs to stimulate economic growth. This perspective also formed a central theme in his re-election campaign.

However, despite officially peaking at 85 percent 11 months ago, annual inflation rates continued to rise, reaching nearly 60 percent in August and surpassing projections made by Erdogan’s newly assembled economic team, comprised of former Wall Street executives and respected technocrats. This team convinced Erdogan that Turkey was on the brink of a systemic crisis unless interest rates were substantially raised.

The policy rate has already surged from 8.5 percent at the time of Erdogan’s re-election to 25 percent last month, with an additional rate hike expected to be announced soon, potentially pushing it to 30 percent. This would mark the highest policy rate in Turkey in two decades, a move that Erdogan endorsed by expressing support for “tight monetary policy” earlier this month.

Despite these changes, economists remain concerned that interest rates in Turkey are still not high enough to combat rising consumer prices effectively. This situation encourages Turks to spend their savings before their value erodes further, resulting in an overheated economy.

While Fitch Ratings recently improved Turkey’s outlook from “negative” to “stable” due to the policy shift, it cautioned that uncertainty remained regarding the success and duration of these adjustments, partly due to political considerations.

Finance Minister Mehmet Simsek, credited with influencing Erdogan’s change in economic policy, anticipates keeping interest rates elevated until the middle of the next year, with discussions about lowering rates possibly starting in the second half of 2024.

Simsek faces an additional challenge in the form of a costly bank deposit support scheme, aimed at compensating for the devaluation of the Turkish lira against foreign currencies. Unwinding this scheme could lead to depositors seeking foreign currencies, putting renewed pressure on the lira, which has already significantly depreciated over the past two years.

Timothy Ash, an emerging markets economist, described the deposit support program as “an unexploded hand grenade placed in Simsek’s pocket by the outgoing team.” He suggested that significantly higher policy rates, bringing them into positive real terms, might be the solution, but it could also require the confidence boost of an external anchor, such as an IMF program.

Despite these challenges, Erdogan has consistently rejected the idea of seeking support from the International Monetary Fund (IMF). The economic future of Turkey remains uncertain as it navigates this dramatic policy reversal and its associated risks.