Turkey Watch – Inflation up, interest rates on hold

by: Nora Neuteboom

  • Inflation surged to 24.5% in September (higher than expected)
  • Albayrak’s inflation plan inadequate to curb inflation
  • We think inflation will remain at elevated levels until mid-2019, before coming down on the basis of weaker demand (recession scenario)
  • We expect the central bank to hold rates at 25 October at 24%
181023-Turkey-Watch-inflation-up-interest-rates-constant_final.pdf (96 KB)

Negative sentiment towards Turkey has eased

In recent weeks, the negative sentiment towards Turkey has eased, which is reflected in a turnaround of the USD/TRY from levels of almost 7 to a current level of below 6. The shift in sentiment was supported by some positive developments, such as the announcement of the New Economy Program and the efforts of Turkish politicians to restore the relationship with the West by, for instance, solving the diplomatic spat with the U.S. over the release of Mr. Brunson. What has helped as well was the sharp (and unexpected) interest rate hike on 13 September (by 625pb to 24%) by the Central Bank of Turkey (CBRT).

Inflation surprised upwards…

The latest inflation data paint a grim picture for the CBRT. Inflation reached almost 25% yoy in September (up from 18% yoy in August), significantly higher than market expectations. The upside surprise was broad-based among the different sub-components, with food prices increasing almost 28% yoy, transportation prices 36% yoy and household equipment 37% yoy.

… so all hands on board…

On October 9, Minister of Finance Berat Albayrak announced a new set of measures to fight inflation. The plan includes a 10% discount on certain consumer goods, regular changes that will bring down the fruits and vegetable prices, a government guarantee that there will be no additional rise in the prices of natural gas and electricity during the rest of this year and an acceleration in VAT rebates. We think these unorthodox measures in itself will be insufficient to counter high inflation. The government also announced that banks will give a 10% on ‘high-interest rate loans’ since the first of August. This will lead to lower financing costs for entrepreneurs on the short-term, but may induce banks to withheld lending going forward. Albayrak’s plan will perhaps have a small effect in the short term, but does not solve the underlying structural issues that cause price pressures.

… but inflationary pressures will remain high

Moreover, Albayrak stated that inflation will reverse after October. He might be right, but the question at stake is whether inflation will return to single-digit territory quickly, or that it will remain at high levels, thereby hurting economic activity. The New Economy Plan projects inflation to come down to 15.9% in 2019. We expect consistently high inflationary pressures in the coming month(s).

  1. There is a remarkable rise in the underlying inflation trend. Both the important core inflation indicators, the so-called ‘B’ and ‘C’[1] inflation indicators, show a significant acceleration. Also the core indicators on a 12 months moving average rate change show a clear upward trend, which indicates that inflation is not driven by volatile factors alone. Producer price inflation reached 46% yoy in September.


  1. Inflation is pushed higher by the exchange rate pass-through effects as the lira has depreciated by around 35% since the beginning of the year, which contributes to higher import prices and rising demand for exports. Earlier research by the Turkish central bank already pointed out that the exchange rate poses a major cost pressure on consumer inflation. While some of this pass-through effect may already have materialized in September, generally exchange rate effects take several months to fully pass through. Moreover, as Turkey is a net-energy importer, import inflation will continue to lift inflation because of increasing oil prices. While the government has committed to keep power and natural gas prices unchanged for two months, this will merely result in a delay in the price pressures, instead of structural lower inflation.
  2. Inflation expectations are not well anchored. Inflation expectations over the next 12 months reached almost 15% in September from 13% a month before. This largely has to do with the policy credibility of the central bank, as it has structurally underestimated inflation and therefore missed its inflation target of 5% year after year (see graph below). This lack of institutional commitment to a nominal inflation anchor has increase price instability.

Given the above factors we expect inflation to rise to 28% in October, before coming down to 24% in December. In 2019, we expect inflation to stay above 20% until the middle of the year, before it comes down swiftly in the remainder of the year to an estimated 12% in December 2019. The disinflation scenario rests on the basis of our recession forecast for 2019. We have a sharp economic contraction as a base case  scenario (-3% GDP growth in 2019), which will help to ease inflationary demand-pull factors. If the economy turns out to be more resilient than we expect, we expect inflation to remain at higher levels.


We expect the central bank to hold rates …

Recently released data, such as the PMI, consumer confidence and industrial production, indicate that a significant rebalancing trend in economic activity is taking place. External demand remains strong and we saw a swift decline in the current account deficit, while signs of deceleration in domestic demand became more visible. Given these deflationary developments, the central bank may want to wait and see what are the lagged effects of their bold action on 13 September and the inflation targeting plan by Albayrak. Monetary policy often takes a few months to translate into lower inflation figures. Therefore, the central bank may want to monitor price stability closely in the coming two months and, if it deviates from the baseline scenario (20.8% end-2018),  take action in December. Thus far, while our year-end forecast for inflation is 24%, the 20.8% is not unattainable. Furthermore, currency pressures have eased last week which may be another argument for the CBRT to wait. The central bank has not aimed at being ahead of the curve in the past, and we think they will not do that going forward. Also noteworthy is that  the CBRT has not communicated any potential policy changes. 10 days before their 13 September hike, the CBRT released a press statement with forward guidance on their monetary stance. Last but not least, president Erdogan’s opinion matters and he may try to persuade central bankers of his unorthodox views (higher rates lead to higher inflation). Given the reasons above, we think that the central bank will keep  rates unchanged at 24% on October 25. Markets are pricing in a small rate hike of 50-100bp.

Is there a possibility that we are wrong?

Predicting monetary policy in Turkey tends to be a hazardous and risky business. The CBRT may feel that current elevated levels of inflation and inflation expectations continue to pose risks on pricing behaviour and accordingly decide to hike interest rates. Admittedly, historically it is quite unusual for Turkey to have negative real interest rates (although we expect that to only be a short-term phenomenon). Though we attach a much smaller probability to this alternative scenario than to our base scenario of unchanged policy rates, it is not unthinkable that the central bank may want to support price stability and raise policy rate by somewhere between 100-200bp.

[1] The ‘B’ indicator relates to the CPI excluding unprocessed food, energy, alcoholic beverages, tobacco and gold and the ‘C’ indicators relates to the CPI excluding energy, food and non-alcoholic beverages, alcoholic beverages, tobacco and gold