Turkey's Inflation Outlook and Central Bank Credibility: Navigating FX and Bond Market Dynamics Amid Policy Uncertainty

The Inflation Conundrum: A Delicate Balancing Act

Turkey's inflation rate surged to 33.29% in September 2025, defying expectations and underscoring persistent price pressures despite aggressive monetary easing by the Central Bank of the Republic of Turkey (CBRT), according to The Financial Analyst. The CBRT has responded with a series of rate cuts, reducing its key policy rate to 40.5% in September 2025-the lowest since late 2023-following reductions to 45% in December 2024 and 43% in January 2025, as AGBI reported. While the CBRT maintains a long-term inflation target of 5%, its February 2025 forecast raised the 2025 year-end inflation outlook to 24%, citing stubborn services and food inflation as external challenges, according to Bloomberg. The bank projects a gradual decline to 12% by 2026 and 8% by 2027, but achieving this will require navigating a fragile economic landscape.

FX Market Volatility and Policy Dilemmas

The Turkish lira has faced relentless depreciation, driven by a combination of domestic policy divergence and external pressures. State banks have intervened aggressively in foreign exchange markets to stabilize the currency, yet these efforts have depleted foreign exchange reserves, signaling systemic fragility, according to Accounting Insights. FX Street reports the CBRT is expected to cut the 1-week repo rate by another 200 basis points to 41% in 2025, despite inflation remaining above 34%. This policy divergence reflects political pressures, as President Recep Tayyip Erdoğan has prioritized economic easing, complicating the CBRT's ability to maintain a tight monetary stance, a dynamic noted in the FX Street coverage. The lira's depreciation further exacerbates inflationary dynamics, creating a self-reinforcing cycle that tests the CBRT's credibility.

Bond Market Resilience Amid Uncertainty

Amid this turbulence, Turkey's local currency bond market has attracted renewed foreign investor interest. In early 2025, foreign investors injected $1.24 billion into Turkish government bonds in a single week, marking the largest inflow in two months and bringing total 2025 inflows to $1.9 billion, The Financial Analyst reported. This trend reflects a shift in sentiment, driven by rate cuts and a gradual decline in inflation expectations. As of December 2024, inflation had eased to 44.38%, and the CBRT's 45% policy rate cut improved the investment climate, The Financial Analyst noted. Analysts highlight the appeal of Turkish bonds for their potential to deliver real returns, particularly as nominal yields remain high and disinflation progresses. However, geopolitical uncertainties and institutional fragility continue to deter crossover investors, limiting the scale of this recovery.

The Path Forward: Credibility at a Crossroads

The CBRT's credibility hinges on its ability to reconcile its inflation-fighting mandate with political and economic realities. While rate cuts have provided short-term relief to borrowers and boosted bond market inflows, they risk undermining long-term price stability. The CBRT's reliance on FX interventions to prop up the lira also raises questions about sustainability, as reserves dwindle and inflation remains stubbornly high. For foreign investors, the key challenge lies in balancing the allure of high nominal yields with the risks of currency depreciation and policy uncertainty.

In the coming months, the CBRT's success in aligning its disinflation strategy with broader economic reforms will determine whether Turkey's bond market can sustain its recovery. If inflation declines faster than projected and the CBRT maintains a disciplined approach, Turkey could emerge as a compelling destination for real yield seekers. However, any misstep in policy execution or external shocks could reignite capital flight and erode investor confidence.