Last Thursday, Turkey’s central bank (CBT) surprised markets by raising its main policy rate from 42.5% to 46.0%. Simultaneously, it increased the overnight lending rate to 49%, and the overnight borrowing rate to 44.5%. Prior to this, we had imagined that CBT would try to avoid hiking the main rate (in an effort not to irk President Tayyip Erdogan) and that this was probably the reason why CBT had resorted to re-starting the use of its infamous ‘rate corridor’ after volatility broke out in the wake of Istanbul mayor Ekrem Imamoglu’s detention. But Thursday’s decisive rate hike by CBT put to rest such concerns and bolstered the credibility of the economic policy team, Commerzbank’s FX analyst Tatha Ghose notes.
Lira recovers briefly as market watches
“The Turkish lira initially rallied back towards its pre-existing 38.0 “line of defence” versus the US dollar. As we see in the chart below, the pattern of intra-day movements changed when policymakers no longer had to defend the exchange rate using interventions. The vertical line in the chart separates the pre-announcement period from the time elapsed since the rate hike – we can easily see the change in pattern of fluctuations from a completely managed (flat) exchange rate line to a freer floating one; one might presume that less active interventions were being required when the exchange rate was able to appreciate of its own accord. Of course, things are reversing, once again, and what will happen in future remains to be seen: one might presume that FX interventions will kick back in soon.”
“Why is USD/TRY drifting up again? The answer is not obvious. The FX market is skeptical of something. One thing is obvious to us: the level of interest rate does not really matter at this point. When CBT started using the rate corridor again, we had written that it would make no difference whether the overnight lending rate were set at 46% or 50% or 60%. It was still an unmitigated disaster that the complex corridor system had been re-invoked. We are now also learning that the market’s perception of CB credibility is a precious commodity and takes time to rebuild. Any flip-flopping within this re-building phase does double damage.”
“How CBT’s credibility will develop in the eyes of the FX market, going forward, remains to be seen. It will depend crucially on how long interest rates can be kept high and how willing policymakers will be to embrace the economic soft patch which will be required to permanently bring inflation down. Unfortunately for CBT, developments of the past quarter were not encouraging: CBT was becoming more complacent, and rates were being cut too fast. When no margin of insurance was left, we now see the inevitable result in the abrupt U-turn which had to be made. We expect that USD/TRY will drift up gradually over the coming quarter pending more show of long-term cautiousness by policymakers.”