The CBRT’s moment

The Central Bank’s Monetary Policy Committee will meet on September 13. At this crucial moment, what can we expect and what needs to be done?

This week’s Monetary Policy Committee meeting will be crucial. What’s at stake?

1 What happened at the last MPC meeting

The previous meeting of the Central Bank was on July 24. At that time, economists were expecting an interest rate increase of 100 basis points. There were concerns, however, over the CBRT’s independence and when the expected step was not taken, the Turkish lira started a downturn that would later turn into a currency crisis.

2 Currency shock

The Turkish lira depreciated very quickly due to the failure of the Central Bank to raise interest rates, as well as high inflation in July, the negative outlook on emerging markets and the Brunson crisis with the U.S. On August 10 alone, the lira lost 20 percent of its value.

3 First response

The Central Bank did not hold an extraordinary meeting to increase interest rates. Instead, it began to fund the market through the top band, disrupting its former commitment to base its entire funding on the one-week repo rate under its simplification program. This meant an implicit interest rate increase of 150 basis points. The Bank also took some steps to limit the Turkish lira in the market with some liquidity measures. Other regulatory agencies such as the Banking Regulation and Supervision Agency increased the cost of selling Turkish lira by, for instance, restricting SWAPs.

4 Inflation expectations wither

According to the Central Bank’s research, under normal circumstances, a decline of 10 percent in Turkish Lira raises inflation by 1.5 points. This points to an exchange rate transitivity of about 6 points. However, the deterioration in pricing behavior indicates that this transitivity may be higher. As of August, the annual CPI is 17.9 percent. Economists expect this figure to be over 20 percent by the end of the year.

5 Calming signal

Following the inflation figures announced on September 3, The Central Bank made a brief statement to calm the markets. “Recent developments regarding the inflation outlook are significant risks to price stability,” it noted. “The Central Bank will take the necessary actions to support price stability. Monetary stance will be adjusted. The Central Bank will continue to use instruments in pursuit of the price stability objective.”

6 Expectations and pricing

After the statement, it’s now assumed that there will be an increase in rates at the September 13 meeting. However, the Central Bank may need to go for a shock increase to meet expectations, as much as 850 basis points according to former Central Bank Deputy Chairman Ibrahim Turhan, taking into account factors such as the inflation forecast, the output deficit, the exchange rate effect on total demand, the transition effect and inflation rigidity. This would mean a policy rate of 26.25 percent. No one expects the Central Bank to raise interest rates to this level. The widespread expectation in the market is that there will be an increase of 250-400 basis points.

7 Political background

President Recep Tayyip Erdogan has often described interest as “the mother and the father” of all problems. He says he is also an enemy of interest. He has often criticized the Central Bank for keeping interest rates high. In an interview with Bloomberg in London before the elections, he signaled that he would take a more active role in Central Bank policies if elected. Therefore, many market players question the independent decision making capacity of the Bank. This perception has had an effect on pricing.

8 Possible economic effects

The Turkish economy is currently in the process of a serious rebalancing. After sizzling growth of 7.4 percent last year and in the first quarter of this year, there are signs of a rapid slowdown. Economists expect a contraction in the third quarter. Even the government is now admitting that 2019 will experience low growth. In this environment, the possible interest rate increase by the Central Bank will deepen the contraction in the economy. Private banks have already stopped giving new loans in Turkey. Credit interest rates are over 30 percent. No company wants to use credit at these rates.

9 Other emerging markets

Developments in Turkey and Argentina had a negative impact on all emerging markets. The currencies of countries such as Brazil and South Africa, where the foreign exchange debt is high, fell precipitously due to the contagion effect. Consequently, the Central Bank of Argentina increased its policy rate by 150 basis points to 60 percent. Other EM central banks have not taken similar steps, yet. However, that may change if the depreciation of their currencies continues.

10 Market sentiment

The sales wave in developing countries is actually a bit exaggerated. For example, Indonesia, where the economy is in a very good condition, was affected by this wave because it is in the Emerging Market category but this is largely due to the market sentiment. Investors are in panic mode, ignoring specific market conditions. This is not the case only for Indonesia. Turkey has had high indebtedness and a high current account deficit for a decade but investors are trying only now to reflect these problems on prices, as if they appeared just yesterday. So normalization may depend more on when the panic subsides rather than the monetary and fiscal steps taken.