The Central Bank once again went beyond market expectations and, within the framework of an unconventional perspective, this time cut rates below the core inflation. Last week, the Central Bank, whic has undergone heavy breaucracy, especially with President Mr. Recep Tayyip Erdogan and President Mr. Şahap Kavcıoğlu meeting, has also removed the lower inflation indicator, which it has focused on recently, from the practtice, emphasized temporary inflation, and added that there is "limited space" in the field of interest reductions for this year. Recently, the Central Bank may have created a perspective more parallel to the view that "high interest rates cause high inflation" within the scope of financing costs of companies. With the dismissal of MPC members (only one MPC member survives from March), who are reluctant to lower borrowing costs and therefore rate cuts, we expect the monetary easing trend to continue within the framework of the decision taken today. On the other hand, we foresee that high inflation will keep the easing area more limited than the rate cut made today.

 

Important notes on today's decisions and policy statement of the Central Bank;

 

·        The one-week repo rate was reduced to 16% (estimate 17%). 15 of 26 economists in the Bloomberg poll were expecting 17%. Estimates ranged from 17% to 17.50%.

·        MPC considers that temporary supply-side factors left limited room for downward adjustment in policy rate until the end of the year.

·        Central banks of developed countries consider that the increase in inflation will mostly be temporary with the normalization of demand composition, easing of supply constraints and reduction of base effects. In this direction, central banks of developed countries maintain their supportive monetary stances and asset purchase programs.

·        Leading indicators show that domestic economic activity remains strong with the help of strong foreign demand.

·        The improvement in the annualized current account is expected to continue in the rest of the year.

·        The recent increase in inflation stemmed from supply-side factors such as the increase in food and import prices, especially energy, and supply constraints, the increase in administered/directed prices, and demand developments due to reopening. These effects are considered to be caused by temporary factors.

·        The tightness in the monetary stance started to exert a more contractionary effect on commercial loans than anticipated.

·        The strengthened macroprudential policy framework began to curb retail loan growth.

·        The Bank will continue to use all available instruments resolutely until strong indicators point to a permanent decline in inflation and the medium-term 5% target is achieved.

 

The Central Bank defines the inflation-increasing risk factors as temporary and continues to direct that "the recent increase in inflation is due to supply-driven factors". Therefore, although the field in terms of near-term policy steps is limited in theory, the fact that the expectation of a decrease in inflation in the coming period is at the forefront indicates that the desire and tendency to reduce interest rates will continue. This shows that the course will continue in a similar way, after the Central Bank's tightening, which gradually decreased after March, was loosened much faster after September. Of course, the fact that the depreciation of the lira along with the increased financial market volatility in this period will be more challenging in terms of inflation also reveals the potential for very important reservations regarding this monetary policy route.

 

The "positive relationship between inflation and interest rates", which is based on the hypothesis that higher interest rates increase the financing costs of firms and reflect this on product prices, is short-lived in an economy like ours, which is heavily imported, since the exchange rate is on the other side of the equation. Therefore, the fact that the interest rates are not high enough and the real return of money, in other words, the decrease in investment attractiveness, causes the exchange rate to increase through the dollarization effect. This, in turn, results in an increase in inflationary pressure on imported inputs and final products. This is how the depreciation and volatility of the local currency return as high inflation. Since the use of imported raw materials and energy inputs in the economy is highly dependent on exchange rates, there are different timing and coefficient effects in terms of its reflection on the prices on the consumer side.

 

Within the scope of inflation and interest rate expectations towards the end of the year, with the decision taken today, these expected levels have already been reached on the interest side. On the other hand, the possibility of further easing cannot be excluded, given the assumption that inflation levels do not currently outline the central bank policy. In particular, we expect the desire for lower interest rates, taking into account the perspective of keeping growth high and easing commercial loans, will be at the core of the formation of this policy trend. Currently, the real interest rate is above -3% as the policy rate is 16%, compared to inflation at 19.6%. After the Central Bank ended its commitment to keep the policy rate above inflation and shifted the focus to core inflation, two consecutive rate cuts caused the negative real return to deepen rapidly.

 

We see that the depreciation of the lira, which was around 20% this year, is well above the EM standard. This is based on a variety factor, which creates a basis for the lira to be less durable within the framework of the new financial conditions to be created by the Fed. In the framework of policy uncertainty, risks of financial instability may cause the market reflection, especially on the borrowing costs side, to not be in line with the decline in official interest rates. In particular, we think that there may be additional situations to the layered effects of the exchange rate within the scope of external borrowing costs. Possibly, we can predict that the Central Bank's changing tangent will have a further depreciation effect on the lira.

 

On October 28, the Central Bank will release the inflation report and increase the forecasts more than in the previous reporting period. We see the risk balance for the 16.2% year-end inflation predicted in the MTP upwards and we expect the deterioration in market-based forecasts to continue. In particular, the policy rate that the CBRT lowered below the inflation indicators despite the "limited area in the interest rate" and the abolition of the practice of "interest above inflation" will raise the question of what criteria will be based on its guidance regarding the next move thresholds.

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