July 25, 2019 / 11:48 AM / 25 days ago

UPDATE 2-Turkish central bank slashes rates below 20% in first shift since crisis

* New central bank governor oversees deep rate cut

* First easing of policy rate in four years

* Turkey’s real interest rate roughly halved to 4%

* Lira strengthens after initial drop (Adds comments, lira update, historical context)

By Behiye Selin Taner and Ezgi Erkoyun

ISTANBUL, July 25 (Reuters) - Turkey’s central bank slashed its key interest rate by a more than expected 425 basis points to 19.75% on Thursday to spur a recession-hit economy, its first step away from the emergency stance adopted during last year’s currency crisis.

The bank lowered its benchmark one-week repo rate from 24%, where it had remained since September, when a collapse in the Turkish lira pushed inflation to a 15-year high above 25%, prompting aggressive rate hikes.

Inflation has since dropped tmsnrt.rs/32KbNrP below 16%, which left Turkey with the highest real interest rate of all emerging markets. That opened the door to the first monetary easing in four-and-a-half years in the Middle East's largest economy.

The lira, which has been volatile this year after a nearly 30% drop in 2018, tumbled immediately after the policy announcement but it quickly bounced back and stood at 5.68 against the U.S. dollar.

The central bank, whose credibility has been questioned anew by investors after its chief was abruptly sacked this month, cited improving inflation and said its stance remained cautious even after delivering the biggest rate cut since at least 2003.

“Maintaining a sustained disinflation process is the key for achieving lower sovereign risk, lower long-term interest rates, and stronger economic recovery,” it said in a statement. “Keeping the disinflation process in track with the targeted path requires the continuation of a cautious monetary stance.”

Economists expected a median cut of 250 basis points, or 2.5 percentage points, according to a Reuters poll last week that showed a wide range of views.

The lira has steadied in recent weeks, even though Turkey faces the threat of U.S. sanctions over its purchase of Russian S-400 missile systems. That stability, along with a recent dovish shift among the world’s major central banks, also paved the way to the easing.

The bank’s new governor, former deputy Murat Uysal, took the reins after President Tayyip Erdogan fired his predecessor, Murat Cetinkaya, saying he had failed to follow the government’s policy instructions.

Reuters, citing sources, later reported the president sacked Cetinkaya a year before his term ended because he resisted requests for a 300-basis-point cut, which prompted some analysts to predict an even sharper easing on Thursday.

A Reuters poll before Uysal took over found economists expected only a 100-basis-point cut.

Any further cuts could put the lira “under substantial depreciation pressures (in part) given markets’ concerns about the central bank’s ability to tighten when needed,” said Ugras Ulku, a former economist at Turkey’s Treasury who is now head of EM Europe research at the Institute of International Finance.

POLITICAL PRESSURE

The policy stimulus could help lift Turkey’s economy from recession, reduce its 13% unemployment rate, and relieve borrowers whose real interest rates were roughly halved to 4% on Thursday, still higher than the average for emerging markets.

Inflation dropped markedly last month to its lowest level in a year at 15.7%, sealing expectations for the cut. The bank said inflation “displayed a significant fall” in the second quarter.

Turkey’s $766-billion economy began contracting last year after the currency crisis was sparked by a diplomatic spat with the United States, a build-up of cheap foreign debt, and worries over the central bank’s independence from Erdogan - who has repeatedly called interest rates “evil”.

A sharp drop since then in the current account deficit and the broader shift by the U.S. Federal Reserve and European Central Bank to a more accommodative stance has helped stabilize the lira, which earlier this year briefly sold off again.

But the new rift with Washington over the purchase of S-400s has set the stage for sanctions that could again rattle the currency tmsnrt.rs/2YPkU84, prolong the recession, and scuttle the central bank's plans for more rate cuts.

“Even though I was surprised by the size of the cut it is still quite reasonable given the current global market environment, and more cuts are coming,” said Marek Drimal, London-based EMEA strategist at Societe Generale.

Erdogan, who suffered stinging local election setbacks this year thanks in part to his handling of the economy, has repeated contrary to monetary theory that tight policy sparks inflation.

Uysal, who has been one of the bank’s more dovish policymakers, said shortly after taking the reins “there is room for maneuver in monetary policy.”

Former governor Cetinkaya hiked rates by 625 basis points in September in a move that many investors saw as too late. Still it helped stem further losses in the lira and put a lid on inflation, even while it helped push the economy into recession.

After Cetinkaya’s dismissal early on a Saturday morning this month, the three major ratings agencies warned about political interference and Fitch cut Turkey’s sovereign rating further into junk territory.

“Everything seems to come from the monetary easing play book of Mr. Erdogan,” said Cristian Maggio, head of EM strategy at TD Securities. “I don’t see anything else striking other than the magnitude.”

Additional reporting by Ali Kucukgocmen, Can Sezer, Ebru Tuncay and Ceyda Caglayan in Istanbul, and Nevzat Devranoglu in Ankara Writing by Jonathan Spicer Editing by Larry King, Dominic Evans and Frances Kerry

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