Turkey’s central bank mulls giant interest rate hike up to 10% to fight inflation

ISTANBUL — Turkey’s central bank is considering a mammoth rate hike of up to 10 percentage points next week to step up the fight against a sticky inflation and boost Ankara’s economic credentials in the eyes of foreign investors, Al-Monitor has learned.

Sources close to the bank’s Monetary Policy Committee (PPK) told Al-Monitor that a possibly drastic hike at the committee’s Sept. 21 meeting stems from concerns over monthly consumer inflation topping 9% in July and August as well as other factors inhibiting efforts to rein in prices. 

With a new economic leadership in charge since June, such a whopping increase would be seen as cementing a reversal from President Recep Tayyip Erdogan’s unorthodox policies of the past several years, largely blamed for Turkey’s current economic woes. The central bank already delivered a bigger-than-expected hike of 750 basis points in August, bringing its benchmark one-week repo rate to 25%. Whether Erdogan — a self-declared “enemy of interest rates” — and his inner circle will approve of another massive hike remains unknown, but the PPK’s new members, who were appointed as part of Erdogan's overhaul in the country's economy management after his reelection, are inclined to raise it by up to 10 percentage points and follow up with other monetary-tightening measures, the sources said. 

In the bank’s assessments, the resurging inflation, which hit an annual high of nearly 60% in August, is a result of the continuing vigor of domestic demand, a consistent services inflation and upward cost pressures stemming from tax and pay hikes and the rising cost of imports due to the weakening of the Turkish lira. And with the added impact of increasing fuel prices, inflation expectations and pricing behavior are deteriorating more than expected. 

Thus, a rate hike of up to 10 percentage points is seen as inevitable to address the main drivers of inflation and meet the objectives outlined in the medium-term economic program that Ankara unveiled earlier this month. By doing so, the central bank also hopes to send a message to foreign investors and international credit rating agencies that it is determined to fight inflation. Sources say that PPK members believe that further big hikes could be needed in the ensuing months. 

The PPK’s chief concern is the recent uptick in inflation. In June through August alone, consumers saw price increases of nearly 24%. As part of the medium-term program, Ankara forecasts an annual inflation of 65% at year-end. Thus, many observers note, the central bank’s 25% policy rate remains insufficient. 

Strong domestic demand

In announcing the rate hike last month, the PPK signaled that it would continue to lean on interest as a weapon. “The committee decided to continue the monetary tightening process in order to establish the disinflation course as soon as possible to anchor inflation expectations and to control the deterioration in pricing behavior,” the statement read. The economic climate, including the pace of price increases, has changed little since then, so the committee feels pressure to show resolve.

The main underlying factor is a continuing strong domestic demand. The retail sales volume index — a key indicator of domestic demand — has continued to rise, increasing 31% in July from the same month the previous year. The same goes for credit card spending. Driven by the vigorous demand, industrial production rose 7.4% on an annual basis in July. The heated economy has been feeding the demand for imports and therefore enlarging the country’s deficit. Turkey posted a current account deficit of nearly $5.5 billion in July, bringing the rolling 12-month deficit to $58.5 billion. Those trends contribute to weakening the lira and rising foreign exchange prices that in turn fuel cost inflation via imports.

To cool the economy to some extent, the central bank’s rate hikes need to be backed up with other monetary-tightening policies. Treasury and Finance Minister Mehmet Simsek announced this week plans to rein in credit growth by limiting vehicle loans and denying housing loans to individuals who are already home owners. Speaking to the NTV channel, Simsek said that new liabilities could be imposed on banks to push them to abide by certain loan volumes in those categories. 

The central bank notes that recent pay hikes by the government are also contributing to the inflationary pressures. A recent report read, “Adjustment in the minimum wage in July 2023, accompanied by wage adjustments for civil servants and public sector workers, and wage hikes becoming broad-based are expected to strengthen the upward pressures, particularly cost-driven impacts, on inflation in the second half of the year.”

But with local elections looming in March, Erdogan is unlikely to back any move targeting wages and salaries for the sake of disinflation. Such actions are likely to be considered only after the polls. 

Meanwhile, cost inflation has been stoked also by tax increases. The government raised the value added tax on an array of items in July and the price-pushing effect of that move is continuing. The fixed increases of the so-called special consumption tax levied on fuel have also driven inflation, both directly and indirectly. The tax hikes have been coupled with increasing foreign exchange costs and rising global oil prices, leading to steep price increases in transportation services and food in particular. Due to mounting transportation costs, fresh vegetables and fruits, for instance, have seen continued price increases despite being in season. 

As for the agricultural supply gaps contributing to food inflation, the central bank can do nothing directly. Invigorating the agricultural and husbandry sectors requires multi-faceted, structural changes.