The Monetary Policy Committee (MPC) narrowed the pace of interest rate hikes from 500 basis points to 250 basis points, in line with its message last month. It raised the weekly repo auction rate from 40% to 42.5%. The text of the rate decision tells that the bank will complete the work on the interest rate side of monetary tightening with a final 250 basis points rate hike in January 2024. Although not the same in nature with the Fed, Turkish central bank notes it will continue with “quantitative tightening” as the next step, will continue to withdraw money from the market (sterilization) by diversifying its tools throughout 2024. The aim is of course to maintain the current monetary policy tightness and perhaps strengthen it depending on the course of domestic demand and inflation.
The first step is a positive real interest rate, but according to end-2024 inflation…
As of early 2024, CBRT’s policy rate will be 45% accordingly. After CPI inflation peaks at 70% in May 2024, CBRT expects CPI inflation to close 2024 at 36%. The market in contrast sees end of 2024 CPI inflation in the range of 40-43%. For the end of 2025, the CBRT’s expectation, which is not yet credible by anyone, is that CPI inflation will be 14%. With a sharper contrast the market expectation is around 25% for the end of 2025.
Therefore, according to its own calculations, the CBRT is trying to make TL bonds attractive for foreign investors by offering positive real interest rates in line with the decline in inflation going forward. Interest rate hikes, which are used to slow down consumption in the fight against inflation, are also designed to replenish the CBRT’s depleted reserves.
As we have observed from fund flows since early December, rising interest rates and monetary policy normalization are attractive for hot money. Foreign investors have been net buyers of TL assets in rather significant amounts amounting to 3.1 billion dollars over the course of last five weeks. It is reasonable to anticipate that this trend will continue to intensify in the first half of 2024. A potential of 15-20 billion dollars seems realizable.
Where will the loan-deposit rate go?
The CBRT is satisfied with the current level of loan interest rates that have followed its rapid journey of rate hikes from 8.5% to 42.5%. It will ensure that they remain at current levels – especially the 60% for consumer loans-for a significant part of 2024.
After completing the rate hikes, it will continue to support monetary tightness with its daily liquidity management. It will continue supporting necessary arrangements for the exit from the fx protected deposit scheme (KKM) as the pace of increase in reserves allows. Among the simplification steps mentioned in the MPC text, the most important step that will be the catalyst to achieve the desired reserve increase and get rid of the KKM scourge is the normalization of the foreign swap market. It is risky to do this before the local elections due to the possible volatility in the TL. It is difficult to take this step without seeing very strong bond demand. On the other hand, if the swap market ban does not lift it is also difficult to receive the significant amounts of foreign money inflows that the bank expects. Therefore, it would be reasonable to expect normalization of the foreign swap market right after the March 2024 local elections.
On the commercial loans side, things could get complicated. Producers, who complained that they could not access credit when interest rates were very low, will start complaining about credit costs as interest rates rise. We will also see these complaints increasing in the second half of 2024, when domestic and foreign demand slow down significantly. Therefore, the door to limited interest rate cuts in the last quarter of 2024 will be opened given these expected pressures from the real sector to politicians.
CBRT’s inflation codes
The Bank promises to maintain “necessary monetary tightness for as long as necessary” to keep inflation expectations on track towards 36% by end-2024 and 14% by end-2025. Hence it is important to understand what this “necessary” means.
With November 2023 CPI inflation at 61,98%, the end of year CPI inflation realization will probably fall short of the 65% the CBRT expects. That is a good thing of course. It gives hope to the bank in terms of its fight against inflation.
Geopolitical uncertainties aside, the continued strength of domestic demand, albeit slowing, and price rigidities in the services sector are obstacles to the CBRT’s target.
It is known that the decision to raise interest rates reflects on the general economy over a certain period of time. If we consider this as 6-8 months for Turkey, the significant impact of the rate hikes to be completed in January will be seen in the second half of 2024. We will see private consumption growth in GDP turn negative. The frequency and rate of salary adjustments in 2024 are important variables for the CBRT in this respect. If there is no second adjustment to the expected January 40-50% minimum wage hike in July, the second half of the year will be difficult for wage earners. hence domestic demand will significantly weaken. Consumer loan rates at 60% will also be supporting this situation.
The rigidity in service price inflation is the main reason for the difference between the end-2024 central bank inflation expectation of 36% and the market expectation of 40-43%. It is much more challenging to anchor the services sector hence the central bank might have to face some nasty surprises there over the course of 2024.
The effect of TL and public finances on inflation and potential interest rate cuts…
Core inflation dynamics suggest that disinflation may go beyond the mechanical base effect in mid-2024. In this respect, foreign capital inflows should continue, and the TL should appreciate by 10-15% in real terms in 2024. For that to materialize the economy should not be accelerated with a new loan drive or excessive public spending. Therefore, the course of public finances will be an important factor in the period before local elections, during 1Q24.
By the end of 2023, the budget deficit will be significantly below the MTP target of 6.4%, at around 3.5%. In 2024, versus another very high official budget deficit estimate the end of year level is to be at 3%, below the MTP target. However, the fact that the deficit to GDP ratio is much higher than it was in 2022 shows that there is not a fully tight fiscal policy implementation accompanying the now tight monetary policy. This is a contradiction when it comes to reducing inflation.
In addition to all this, after the summer months of 2024 when the base year effect will kick in on annual inflation, in other words the fast slide from 70% yoy headline inflation, it will most likely coincide with the start of the Fed’s rate cut period in fall 2024. Fed and ECB rate cuts are likely to inspire the CBRT, by when real sector complaints to Erdoğan about high loan rates and appreciating TL will mount.
More precisely, in the last quarter of 2024, it is highly likely that the CBRT will cut the policy rate from 45% to around 38-40%. CPI inflation, which will arguably reach 36% by the end of 2024, will then become impossible to reach 14% by the end of 2025. A rate cut in the last quarter of 2024 would also start the phase in which foreign capital flows directed towards Turkish bond yields would get stagnant on net terms. The calm course of the TL throughout the year will hence end in the last quarter of 2024.
Any further rate hikes beyond 45%
Can the CBRT take the other route and rise the policy rate after the local elections given continuing strong demand? The answer would be highly unlikely. It would rather go for brand new quantitative tightening measures to put a stronger cap on consumption related loans making them even more expensive.
The CBRT will still be favoring positive GDP growth in 2024 and that requires a rather tamed flow of loans to real sector and not a sudden stop. There is the possibility of a referandum on Constitution in 2025 perhaps which means another ballot box. For Erdogan to conquer an official third term via constitutional change he needs the economic growth to be in rather good shape.
GA.