The Turkish lira is facing an inflation spiral and its central bank may need 'outside help' to fight the crisis and regain foreign investors' trust, Commerzbank says

• Markets are seeing a repeat of the 2018 crisis, which was also triggered by presidential policy, Commerzbank said.
• The Turkish lira is facing the risk of a damaging inflation spiral, according to the bank.
• Turkey's central bank may need 'outside help' to fight the crisis and regain investors' trust, the bank said.

The Turkish lira has hit record lows this week, domestic markets are in turmoil after the surprise sacking of the head of the central bank and the currency is facing a crisis and a damaging inflation spiral, according to analysts at Commerzbank.

"The next lira crisis is upon us," Tatha Ghose, a foreign exchange and emerging markets analyst, at Commerzbank said in a note on Tuesday.

President Recep Tayyip Erdogan installed the third central bank chief in just two years earlier in the week, firing incumbent Naci Agbal, whose approach to monetary policy had won the confidence of domestic and foreign investors alike. Agbal last week raised interest rates to 19% from 17% to head off a pickup in inflation, angering Erdogan, who has made clear he believes higher interest rates boost inflation. This contradicts traditional economic theory, which argues the reverse.

Inflation could now spiral to over 20% by the end of the year as a result, Commerzbank's Ghose said.

"...He must truly believe that lower interest rates will solve Turkey's current macroeconomic problems even in the short-term; otherwise it is difficult to believe that the president would risk another lira crisis already, when private sector balance sheets are reeling from a massive FX liability burden," he said, referring to Erdogan's macroeconomic beliefs.

"We saw similar presidential involvement in monetary policy right before the last lira crisis in 2018," Ghose said. "This particular experiment risks ending in an FX-inflation spiral," he added.

Whilst it is impossible to predict what form the new Turkish monetary policy will take, it is highly likely that interest rates will be cut back to around 13%, which will cause inflation to strongly accelerate in the next nine months, the Commerzbank report said.

The value of the lira against the US dollar is likely to depreciate and risks going exponential, but medium-term policies and developments are impossible to predict, Ghose wrote.

Following the firing of Agbal, investors fled the Turkish market on Monday. The benchmark Borsa Istanbul 100 index had fallen over 5% at close, but turned positive on Tuesday, similarly the lira recovered slightly. It is however still at record lows against the dollar and investors are continuing to pull funds from the Turkish market. The yield on the benchmark 10-year sovereign bond was up by more than 1 whole percentage point on the day at 19.24%, the highest since the last lira crisis in 2018.

By starting yet another cycle of unstable monetary policy, Erdogan "has thrown monetary policy credibility out of the window," Ghose said. Even policies designed to stabilize the central bank, or rate hikes would not be enough to calm investor worries, as this cycle has repeated itself too often by now, he said.

"For the lira to stabilize, some sort of regime change, or institutional hand-over may be necessary - for example, under IMF supervision - which will restore credibility," Ghose said.