Turkey’s Central Bank Signals Lower Effective Funding Rate Ahead

Turkey's central bank hiked its inflation forecast to 28% from 26% previously, bringing it more in line with current market expectations. It also signalled that the effective policy stance is likely to normalise with a shift in funding from the overnight lending facility back to the repo window

Central Bank of Turkey Governor Fatih Karahan presented the year’s third Inflation Report on Thursday, unveiling updated projections at a time when market participants had been questioning the timing of the expected easing in liquidity conditions.

In the meeting, Governor Karahan's key message was that the normalisation of liquidity conditions remains on the agenda. This would lower the effective funding rate from 40% to 37%, although he did not indicate when such a move might take place. While we had expected this to happen in September, the case for an earlier move in August has strengthened. According to the governor, the worst of the US-Iran conflict appears to be over, and under current conditions, he does not expect any severely adverse developments. As for the factors shaping the inflation outlook, the economic slowdown has become much clearer, particularly in domestic demand indicators. Therefore, while inflation expectations have deteriorated somewhat, the upside risks to the inflation outlook have continued to fade. Against this backdrop, the bank may consider restarting one-week repo auctions and providing funding from the policy rate.

In comparison to the previous report, the bank has kept inflation targets flat at 24%, 15%, and 9% for this year and the next two years, respectively. Still, the CBT hiked the forecast for 2026 to 28% from 26% earlier, bringing it closer to the market forecast, which stood at 29.2% in the latest survey. For next year and 2028, the forecasts are unchanged, remaining aligned with the targets.

The hike for this year reflects a combination of changing assumptions related to several key drivers: i) a slightly downward revision to external demand ii) a cut (from US$89.4 to US$87.8) in oil prices, which retreated following the ceasefire but rose again with subsequent tensions in July iii) higher import prices on the back of diesel refinery margins, natural gas and commodity prices excluding energy iv) an upward adjustment in food inflation to 28.5% from 26.3% due to recent data, and the outlook for agricultural commodity prices. In the current highly uncertain environment, the CBT sees risks stemming from: i) energy prices, on both the upside and downside; ii) food prices, which remain vulnerable to positive and negative supply shocks as well as war-related pressures on global markets; and iii) "more frequent and successive supply-side shocks", which could reinforce inflation persistence.

The governor added that the Bank has not changed its 2027 forecast given ongoing geopolitical risks, which could potentially impact the 2027 outlook, and ongoing preparations for the medium-term plan (MTP), which could lead to revisions in the macro framework. Accordingly, they will revisit the 2027 forecast in the MTP process and make changes if needed.

Regarding the other issues discussed in the meeting:

i) Concerns were raised regarding the impact of the current policy framework, with higher financing costs and exchange rate developments weighing on the production capacity of the industry sector. According to the governor, the CBT is closely monitoring the issue along with several important factors affecting the industrial outlook beyond the stance of monetary policy. The most significant factor is the external demand environment, which has been influenced by a range of developments in the last few years, including geopolitics. A second factor is the rise in protectionist policies in global trade. On the domestic side, there has been a shift in economic activity from manufacturing to services as part of a normal development process. In addition, within the industrial sector itself, there is an ongoing transition toward higher value-added and more technology-intensive industries.

According to Karahan, there is no indication of a deterioration in supply capacity. The decline in industrial production primarily reflects lower capacity utilisation rather than a reduction in productive capacity. At the same time, productivity has increased significantly, suggesting that higher levels of output can be generated with existing resources.

ii) Following the pandemic, significant volatility was observed in the Net Errors and Omissions (NEO) item of the balance of payments. Such fluctuations may be considered relatively normal over the short term. However, in 2021 and 2022, the NEO balance recorded exceptionally large positive inflows, while since 2023 it has posted a substantial cumulative negative balance of around USD58bn.

Three separate revisions were introduced to address this issue, with the adjustments relating largely to items recorded under the financial account. These included: (i) a more accurate measurement of bank deposits held abroad by residents; (ii) improvements in the classification and recording of financial derivatives and (iii) the decomposition of domestically-driven foreign banknote movements from external transactions. As a result of these revisions, the cumulative negative balance in the NEO account declined significantly, falling to USD23bn.

iii) In the 2026 strategy, the CBT planned to increase its OMO (Open Market Operations) portfolio to TRY450bn this year. The bank has already purchased TRY220bn, bringing the portfolio up to the target, though it has declined recently due to maturities and they may replenish that amount.

Additionally, given developments over the course of the year, the balance sheet size has been running somewhat above the level the bank had initially projected and determined the target size for the portfolio. Therefore, the CBT is likely to revise the target upwards and determine the timing of purchase auctions in the period ahead.

iv) Food inflation has been elevated recently despite expectations of strong agricultural production this year. Accordingly, the bank has examined the drivers of food inflation and concluded that agricultural input costs do not fully explain the recent increase. This suggests factors beyond input cost pass-through are at play and these structural factors help explain why food inflation can remain elevated even when underlying agricultural cost pressures are relatively contained.