Turkey's central bank is easing by stealth. That is a dangerous game

THE CENTRAL Bank of the Republic of Turkey has left its policy rate unchanged at 37% for the fourth consecutive month. Yet the bank has nevertheless eased monetary conditions, quietly pulling the effective cost of funding banks back down from the dizzying heights it reached earlier this summer. The mechanism is not a headline interest-rate cut. It is a shift in how the central bank lends to the banking system, moving liquidity provision from overnight facilities — where rates had crept to around 49% — back to the one-week repo window at the official policy rate. The difference of 12 percentage points matters a great deal.

This is not the kind of transparency that central banks usually champion. It is, however, the kind of manoeuvre that a central bank in Turkey's position finds irresistible. The political pressure to cut rates is intense. The economy is slowing, domestic demand is weakening and industrial capacity utilisation is falling. But the inflation target has been revised upward to 24% for the second half of the year and annual consumer inflation was 31.75% in July. An outright rate cut would risk the hard-won credibility that the current administration has built since abandoning the heterodox low-rate policies of the previous era. Shifting the effective rate down while keeping the headline number intact is an attempt to have it both ways.

How it works

Central banks typically set a single policy rate and lend to commercial banks at or near that level. Turkey's central bank has done something different. Over the past couple of months it has provided most of its liquidity through overnight lending facilities and term deposits at rates far above the stated policy rate — effectively creating an upper corridor that pushed the actual cost of money to around 49%. This was an extra layer of tightening, intended to keep credit tight in the face of surging inflation driven partly by the war between America and Iran, which spiked energy and import prices.

Now the bank is reversing that arrangement. Governor Fatih Karahan signalled during the presentation of the third inflation report on August 13th that the bank intends to restart one-week repo auctions and provide funding directly at the 37% policy rate. The effective rate would thus fall from 49% to 37%, a move roughly equivalent to three successive rate cuts of the kind markets have been expecting. It is easing by stealth.

To be sure, the central bank calls this "liquidity normalisation", and there is a technical logic to the term. The overnight lending spike was an emergency response to unusual market turbulence, and returning to standard repo operations is what central banks normally do when conditions settle. Yet the timing matters. The worst of the geopolitical shock has indeed receded, as Mr Karahan has noted, and the economic slowdown makes the 49% rate harder to justify. But the decision to keep the headline rate at 37% while pulling the effective rate down is not the same thing as returning to business as usual. It is a calibrated loosening that preserves the appearance of tightness.

The inflation problem

The arithmetic is not encouraging. The central bank has raised its end-of-year inflation forecast from 26% to 28%, citing higher diesel, natural gas and non-energy commodity prices, along with food inflation now expected at 28.5% by year's end. The interim inflation target for the second half of 2026 stands at 24%. Easing the effective funding rate while inflation sits at nearly 32% is an unorthodox move, even for an emerging-market central bank with inflation problems.

The standard central-banking playbook would demand that rates stay restrictive until inflation is clearly and sustainably falling toward target. Turkey's central bank does not claim otherwise. Mr Karahan has said the tight monetary policy stance will be maintained until price stability is achieved. But the funding shift contradicts the spirit if not the letter of that promise. A fall in the effective rate of 12 percentage points will lower borrowing costs for households and businesses, which should stimulate demand — precisely the thing that inflation-fighting is supposed to restrain.

Why this approach may backfire

The trouble is that financial markets do not care about the distinction between a headline rate cut and an effective rate cut. What matters is the actual cost of money, and that is falling sharply. If markets perceive the move as easing — and they almost certainly will — the lira is likely to weaken further. The currency has already depreciated around 16% over the past 12 months, touching 47 to the dollar in July and 56 to the euro in late August. A further slide would feed import inflation, offsetting the very price relief that lower rates are supposed to bring.

Worse, the manoeuvre risks undermining the institutional credibility that the central bank has spent years rebuilding. The credibility of any central bank rests on the public's belief that it will do what it says it will do. If the stated policy rate is 37% but the effective rate moves between 37% and 49% depending on the governor's mood and the state of geopolitical tensions, then no one knows where policy really is. That uncertainty itself fuels inflation expectations, because businesses and workers do not know whether to price for a future of high rates or falling ones.

It is tempting to think that this kind of flexibility gives the central bank more tools. In practice it gives it fewer. The whole point of a transparent policy rate is that it communicates a clear signal to the economy. By obscuring the true stance of monetary policy behind a maze of overnight facilities, term deposits and repo auctions, the central bank makes itself harder to understand and therefore less able to steer behaviour.

The stronger case

The most defensible approach would be straightforward. If the economic slowdown and fading geopolitical shock justify easing, cut the policy rate openly and accept the political cost. If inflation at nearly 32% demands more time, keep the effective rate where it is and explain why. Either path is honest. The current one is neither.

The central bank inherited a mess from the previous administration, which treated interest rates as a political football and cut them during inflation on the grounds that high rates caused prices to rise. That heresy destroyed the lira and sent inflation soaring. The current government reversed course and rebuilt credibility through painful rate hikes and a willingness to keep money expensive. That was the right choice. It should not be abandoned now for a half-measure that satisfies neither the economy's need for credit nor the public's need for anchor.

What to watch

The immediate test is the lira. If the currency holds steady while the effective rate falls, the central bank can claim that markets believe inflation is under control. If the lira slides, the market will have spoken: it sees the funding shift as premature easing, and it will price that into import costs, wage demands and long-term borrowing spreads.

The second test is the pace of the shift. Governor Karahan has left the timing of the repo restart deliberately vague, with market participants debating whether it will happen before the September policy meeting or after. A gradual, transparent wind-down of the overnight lending programme would be the least damaging path. An abrupt switch from 49% to 37% overnight would be a shock that the banking system and the currency markets might not absorb calmly.

The third test is what the central bank does when — not if — the political pressure for further easing intensifies. If the funding-shift gambit succeeds in lowering borrowing costs without triggering inflation or a currency crisis, it will be tempting to repeat. That would turn a one-off adjustment into a permanent opacity, and the bank's credibility would evaporate. The aim should be to return to a single clear policy rate, not to invent a permanent middle ground between the stated rate and the effective one.

Turkey's central bank has earned its hard-won reputation by doing the difficult thing honestly. It should not trade that credibility for a temporary political reprieve.