Turkey: lessons from previous easing cycles - Capital Economics
Emerging Europe Economics

Turkey: lessons from previous easing cycles

Emerging Europe Economics Update
Written by Jason Tuvey

Turkey’s central bank looks set to cut interest rates further over the coming months, but past experience suggests that the easing cycle will be short and that renewed lira weakness will eventually force policymakers to reverse course. We expect rate hikes to come onto the agenda in the second half of 2020.

  • Turkey’s central bank looks set to cut interest rates further over the coming months, but past experience suggests that the easing cycle will be short and that renewed lira weakness will eventually force policymakers to reverse course. We expect rate hikes to come onto the agenda in the second half of 2020.
  • Last week, Turkey’s central bank followed up July’s aggressive 425bp interest rate cut with a larger-than-expected 325bp reduction. With inflation likely to fall sharply in September and October owing to base effects, coupled with ongoing pressure from President Erdogan, the easing cycle has further to run.
  • Recent history can provide some guidance to how the easing cycle is likely to develop over the coming months. We have looked at the last three rate cutting cycles in Turkey which started in 2012, 2014 and 2016 respectively. Overall, three key messages emerge. First, monetary easing cycles in Turkey are getting shorter. Interest rates were lowered over the course of a year from March 2012. But the easing cycle in 2014 lasted nine-and-a-half months, and the cycle that began in 2016 was even shorter.
  • Second, successive easing cycles are reaching a trough at higher rates. In 2013, the CBRT’s average cost of funding fell to 4.50%. But in 2015 and 2016, rates bottomed out at 7.60% and 7.70% respectively. This reflects the CBRT’s failure to anchor inflation expectations, which results in each inflation shock having a longer-lasting effect on wage- and price-setting behaviour, and thus the need for higher nominal rates.
  • Third, the lira tends to be best predictor of when the central bank starts to hike interest rates again. All three of the past tightening cycles have commenced after the currency has fallen by around 5% against the dollar within the space of a month. (See Chart 1.)
  • Political pressure on the CBRT means that it is likely to fully reverse last year’s monetary tightening. Our forecast is for the one-week repo rate to be lowered by an additional 400bp, to 12.50%, by early next year. And there’s a risk that President Erdogan forces the MPC to take even more aggressive action – he recently called for rates to be returned to single digits.
  • Even so, we think that the CBRT will have to shift tack before long. Aggressive easing means that Turkish inflation will not come down sustainably. After falling sharply in the next couple of months, we expect the headline rate to start creeping up again. One result of this is that the lira will need to depreciate in order to limit any rise in Turkey’s real exchange rate and maintain the country’s external competitiveness.
  • What’s more, the lira is likely to face a bumpy ride. In its latest Inflation Report released in July, the central bank pinned a lot on Turkey’s risk premium continuing to diminish. But looser monetary policy is likely to fuel domestic demand and cause the current account balance to start deteriorating again. This, coupled with the country’s large external debt burden, leaves the lira vulnerable to bouts of risk aversion.
  • And there are plenty of flashpoints on the horizon. If global growth stays subdued and the trade war continues to escalate, investor risk appetite is likely to wane. And the threat of US sanctions on Turkey has reared its head again. Our forecast is for the lira to end 2020 at 7.50/$, a fall of more than 20% from its current level. (See Chart 2.) Against this backdrop, we expect interest rate hikes to come back on to the agenda in the second half of next year.

Chart 1: Fall in Turkish Lira Against Dollar From Peak in Month Prior to Start of Tightening Cycle (%)

Chart 2: Turkish Lira (vs. $, Inverted)

Sources: CEIC, Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Jason Tuvey, Senior Emerging Markets Economist, +44 20 7808 4065, jason.tuvey@capitaleconomics.com

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