ISTANBUL -- Turkey's central bank stunned markets on Thursday by slashing its key interest rate a full percentage point, with the lira plunging to record low levels.
The Monetary Policy Committee had been widely expected by forecasters to hold its one-week repo rate steady at 19%, but instead cut it by 100 basis points to 18%.
Central bank Gov. Sahap Kavcioglu was appointed by President Recep Tayyip Erdogan in March after his predecessor Naci Agbal was sacked following a hawkish 200 basis point hike to control inflation. Kavcioglu is the fourth person to hold the office since the beginning of 2019 at the central bank, which has faced repeated leadership dismissals from Erdogan.
"Once again, investors were caught out by an excessively dovish central bank," Erik Meyersson, senior economist at Handelsbanken Capital Markets, told Nikkei Asia.
"In this case, there were clear indicators that a cut was to be expected given President Erdogan's speeches as well as how the central bank had previously updated its guidance shifting focus from headline to core inflation, arguably for the purpose of generating the official space for a cut," Meyersson said.
The Turkish currency dropped 1.5% following the rate cut, hitting 8.8 lira to the dollar.
Ali Hakan Kara, a former chief economist of central bank tweeted: "For 16 years I drafted monetary policy committee texts, but never saw a decision taken with such strained reasoning. I hope we will end up all right..."
After the sacking of his predecessor, Kavcioglu pledged a "policy rate to be determined at a level above inflation" in an attempt to ease market turmoil.
But the new central bank governor abruptly changed his guidance in September, after Erdogan said in August that inflation would peak in that month and "a drop at interest rates will be seen" because "from now on it's not possible for inflation to go higher."
Despite Erdogan's assurance, headline inflation continued to increase in September to 19.25%.
Kavcioglu had signaled the stage was set for a rate cut by twice stating the central bank would shift its focus to core inflation, which omits volatile items like energy and food, instead of headline inflation. This change was described as driven by temporary inflationary factors brought on by the pandemic.
In Thursday's statement, the Monetary Policy Committee said it evaluated "the impact of demand factors on which monetary policy can have an effect, core inflation developments and supply shocks.
"Accordingly, it is judged that a revision in monetary policy stance is needed and the policy rate was decided to be reduced," the bank's statement said.
New core inflation guidance provides about 250 basis points of wiggle room above headline inflation.
Piotr Matys, senior foreign exchange analyst at InTouch Capital Markets, warned that today's decision could prove counterproductive as it leaves the lira even more vulnerable to the prospect of the U.S. Federal Reserve tapering its monetary stimulus.
"We've seen this before -- the central bank of Turkey starting an easing cycle when room for maneuver is limited by persistently high inflation and hoping that the lira will not weaken on the back of negative real interest rates," Matys said. "It did not end well in the past and may have similar consequences during this easing cycle most likely resulting in the lira depreciating to a new all-time low."
While Kavcioglu's point about pandemic factors may be right, "the central bank hasn't been particularly successful in controlling inflation even before the pandemic started," Matys said.
"The 100 basis point cut is also likely to be interpreted by the market as a confirmation that the central bank is under political pressure." Matys added.
Erdogan is under pressure to deliver economic growth as he looks ahead to seeking reelection in 2023. The approval ratings of both the president and his ruling party are at the lowest levels to date, according to a poll conducted by Istanbul Economy Research.
Erdogan has called interest rates the "mother and father of all evil" and holds an unorthodox view that high interest rates cause inflation, the opposite of the mainstream economic theory.