MNI INTERVIEW: CBRT Will Raise Target, Tighten - Demiralp

Turkey’s central bank is likely to further raise rates and increase its year-end inflation target in response to worsening inflation expectations, a depreciating currency and rising fiscal pressures, a leading Turkish economist told MNI.

The CBRT’s decision earlier this month to interrupt an easing cycle begun last December and raise its policy rate from 42.5% to 46% following a market selloff in the wake of the arrest of a leading opposition figure sent a "strong signal" that it is willing to do what is needed, Selva Demiralp said in an interview. 

"Most people seem to expect the next move to be a rate cut. But looking ahead, I think they might actually need to tighten further,” she said.

Rates were the tool to hand after the CBRT deployed around USD52 billion to defend the lira, draining central bank net reserves to only around USD20 billion, she continued. 

“They’re also still lending at the upper bound of the interest rate corridor, which is why the average interest rate is around 48%. Simply put, they can’t afford to keep selling reserves at that pace,” she said. “But as we saw back in 2021, even when their reserves dropped as low as negative USD125 billion, they managed to keep things going for a while through swap arrangements.”

LIRA WEAKNESS

At World Bank-IMF meetings last week CBRT Governor Fatih Karahan cited a spillover rate from lira depreciation into inflation of 35-40% - which Demiralp said was too low, noting that this rate had reached 100% in extreme cases.

“If we look at the period from March 19 to today, the Turkish lira has depreciated by about 4.75%. If we assume a 100% spillover, that alone would add almost five points to the inflation rate. Even if we take a more moderate spillover rate — say 50% — it would still mean an extra two and a half points.”

With 12-month household inflation expectations rising from 66% in March to 68% in April and confidence slipping, a year-end inflation target of 24% - set by the bank in February - and a government growth target of around 4%, look out of reach, Demiralp said. Instead, inflation of 36% and growth close to 2.5% appear likely. (See MNI BRIEF: CBRT On Track To Hit 2025 Inflation Target - Simsek)

“I would expect the CBRT to revise up its inflation target — probably in May, when the second Inflation Report of the year is released — because 24% is just way too optimistic. Maybe they’ll raise the baseline to 26%, which would push the upper bound to 32%. If inflation then reaches 36%, they’d probably still feel relatively comfortable.”

Most demand for reserves comes from local firms with foreign currency liabilities, she noted. 

“One way the central bank is trying to limit dollarisation is through the forward FX contracts they’re arranging. Another option — if they wanted to be a bit more creative and if the demand is still there — would be to introduce some form of FX-protected savings instruments again.”

TAX PROMISES

Households anticipate a 13% uptick in foreign exchange demand over the next 12 months, though higher rates have made lira-denominated savings more attractive, Demiralp noted.

“The question is whether it will be enough if underlying political tensions remain high. One possibility is lowering the capital gains tax to boost the real returns on lira-denominated assets.  Another step the central bank could take would be to use swap agreements to circulate reserves within the system, which could help keep the economy running more or less the way it is now, at least until the next election.”

Domestic demand has cooled, but continues to exert upward pressure on prices, while services inflation remains sticky. The CBRT’s emphasis on coordination with fiscal policy is a tacit acknowledgment of monetary policy’s limits, Demiralp said. 

“You can’t taper demand differently across income groups with monetary policy alone. And it’s also worth noting that fiscal spending is notoriously hard to rein in,” she said, noting that tax increases for higher-income groups promised by Finance Minister Mehmet Simsek last summer have yet to materialise.

“Without that, it’s very difficult to control services inflation. I think, implicitly, that’s what Fatih Karahan is trying to highlight.”