Turkey's Falling Currency Has a New Enemy

Inflation hurting the Turkish lira

The Turkish lira has been on a noticeable decline since September 2016. We saw one of the reasons for its slide in the previous article of this series.

The other reason for its downward spiral is the high level of inflation being witnessed in Turkey. Inflation surged to 8.5% in December from 7% in November. The fall in the Turkish lira has also caused jitters in the equity and debt markets, leading to a decline in stocks (TUR) and a rise in bond yields.

Turkey’s economy has gone from posting growth in the first half of 2016 to reporting a contraction in Q3. With economic activity contracting, inflation should be falling as well, but the ill effects of the decline in the Turkish lira are weighing on the price rise.

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In December, Turkey’s President Recep Tayyip Erdogan asked the Turkish people to sell foreign currency and buy the lira in order to provide support to the domestic unit.

The dilemma of the central bank

Given the theoretical background regarding the relationship between inflation and exchange rates, we can consider the dilemma faced by Central Bank of the Republic of Turkey (Türkiye Cumhuriyet Merkez Bankası)

In order to get the economy back on track, the central bank needs to cut interest rates. However, this will further fuel inflation. Meanwhile, if it raises rates in order to rein-in inflation, it can weaken the Turkish lira further, apart from hurting economic output.

The central bank had raised interest rates in November even after being under pressure from Erdogan´s government to provide cheaper credit. The 50 basis point increase effected on the one-week repo rate to 8% was the first increase since January 2014.

By undertaking the move, the central bank has shown its intent to support the currency. Hence, in the upcoming meeting in January, a further uptick in rates is possible. However, it remains to be seen whether political pressure will deter policymakers from raising rates this time around.

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