Turkey has seen a series of economic policy developments over the last few weeks, including a large hike in the minimum wage and the introduction of a forex-protected Turkish lira deposit scheme. Meanwhile, inflation and inflation expectations have surged amid deeply negative real interest rates. While we had projected a spike in inflation in December 2021 following sharp depreciation of the Turkish lira from mid-November, the actual outcome was significantly higher than our expectations and those of the market. We attribute this largely to a stronger and faster pass-through of exchange-rate depreciation to domestic prices.

We now expect annual inflation to exceed 50% for most of the year. It should decline in December on a base effect, but remain above 30%. Accordingly, we have raised our forecast for annual average inflation to 49.5% in 2022 and 14.5% in 2023. Turkey's overall macroeconomic trajectory remains highly uncertain amid a lack of clarity on the direction of its economic policy. We have therefore maintained our projection for 2022 baseline GDP growth at 3.7%, and we see both upside and downside risks to this estimate. Our next full forecast revision is scheduled for March 2022, and we will publish it in our quarterly economic outlook for emerging countries in Europe, the Middle East, and Africa.

External conditions are changing as well, suggesting that inflation could rise even higher. Oil prices have hit seven-year highs through a combination of strong supply-demand fundamentals and, to a lesser degree, geopolitical events that have limited supply and added a degree of uncertainty. While we continue to expect that oil prices will fall from current elevated levels, we now see them stabilizing at $75 per barrel (/bbl) for the rest of 2022, up from our previous projection of $65/bbl (see "S&P Global Ratings Revises Oil And Natural Gas Price Assumptions For 2022-2024," published Jan. 20, 2022, on RatingsDirect). As a substantial net energy importer, Turkey has already felt the impact of soaring international energy prices on inflation keenly. Recent developments suggest a delay in the disinflationary impact from the expected easing of oil prices, with pro-inflationary risks from potentially higher prices building.

Meanwhile, emerging markets face the start of a tightening cycle by the U.S. Federal Reserve (Fed). The U.S. Federal Open Market Committee statement on Jan. 26, 2022, made it clear that the Fed's interest rate rocket is heading to the launchpad and preparing for lift off (see "The Federal Open Market Committee's Policy Rocket Heads To The Launchpad," published Jan. 26, 2022). S&P Global Ratings now expects the Fed to raise rates in March 2022, the first of at least three 25-basis-point rate hikes this year. Our analysis suggests that external imbalances will be the main channel of transmission of the faster-than-expected Fed tightening cycle for Turkey. This is because the country's external financing needs remain large due to its high level of external debt, even if the current account is in stronger shape than in previous Fed tightening cycles. Turkey also stands out as having the lowest reserve adequacy among major emerging markets (see "How Prepared Are Emerging Markets For The Upcoming Fed Policy Normalization?," published Jan. 27, 2022).

Inflation Has Surged Amid A Stronger Exchange-Rate Pass-Through

The January 2022 inflation figures published today show that Turkey's headline inflation increased by 11.1% on the previous month. Annual inflation is now running at 48.7%, up from 36.1% in December. In part, this reflects large increases in administrative prices, including a hike in gas and electricity prices and taxes on alcohol and tobacco. Even so, excluding administered prices, consumer prices jumped by 8.8% in January. Meanwhile, producer prices increased by 10.5%, or 93.5% on an annual basis.

Turkey's currency has been under renewed depreciation pressure since September 2021, following a series of policy rate cuts amounting to 500 basis points (bps) amid high and rising inflation. As pressures on the currency intensified, the lira-to-U.S. dollar exchange rate dropped by around 30% between mid-November and end-December 2021. It briefly touched much lower levels in December amid extreme volatility.

The pass-through of exchange-rate depreciation to domestic prices is an important determinant of inflation in Turkey. This reflects the country's sizable share of imports in domestic production and consumption, as well as the role of the exchange-rate dynamics in inflation expectations. The high level of foreign-currency debt in the Turkish corporate sector is also likely to play a role. Research from Turkey's central bank has shown that higher foreign-currency indebtedness raises the degree of exchange rate pass-through.

Our estimates show that the short-term exchange-rate pass-through on domestic prices has been around 20% in recent years. This means that a 10% fall in the trade-weighted exchange rate of the lira adds around 2.0 percentage points (ppts) to inflation over a two-month period. That said, it is well known that exchange-rate pass-through tends to be stronger during episodes of large depreciation in Turkey and other emerging markets. This makes it more difficult to estimate the likely impact of a large depreciation on domestic prices based on historical correlations.

It appears that exchange-rate pass-through has been particularly large over November 2021-January 2022, even exceeding that in the aftermath of an abrupt fall of the Turkish lira in August 2018. The magnitude of depreciation is similar to that in 2018. The lira exchange rate trended down for much of 2018, dropping by about 30% versus the U.S. dollar over August and the first half of September. In annual terms, the trade-weighted lira was 76% weaker by September 2018, measured as foreign currency per lira (see chart 1). In December 2021, the trade-weighted lira was 70% weaker compared to the year before. And yet inflation has been much higher than in 2018. In 2018, consumer prices increased by 12.0% over August-October, and inflation peaked at 25.2% in October, before receding fairly quickly on the back of the appreciating lira. Over November 2021-January 2022, consumer prices jumped by one-third, while annual inflation surged to close to 50%. This is double the 2018 peak, and the highest annual reading since April 2002.

Chart 1

The Difference In Inflation Between Now And 2018 Is Largely Down To Domestic Policy

While external factors partly explain the much higher inflation today, in our view, the key factor is the difference in domestic policy. For sure, the external environment is much more inflationary than in 2018. Surging commodity prices and supply-chain disruptions together with a robust economic rebound have pushed inflation up globally. In Turkey's case, currency depreciation is amplifying these effects. Turkey's domestic energy prices--including fuel and heating components--have been rising fast through most of 2021, reaching 50% year on year in December. Energy price inflation alone contributed close to five ppts to annual inflation in December 2021 (see chart 2). The rise in global food prices has also added to inflationary pressures, with food price inflation contributing 12 ppts to annual inflation in December.

Chart 2

However, the differences in domestic policy are arguably more important. In September 2018, the Turkish central bank hiked the key rate to 24%, 675 bps higher than in early August 2018. This helped stabilize the exchange rate and reset inflation expectations. Today, the authorities have showed a strong preference for lower rates, and generally a much greater tolerance for a weaker lira. The policy response to extreme pressures on the lira in December 2021 included foreign-exchange intervention and the introduction of various measures, such as a forex-protected Turkish lira deposit scheme and the requirement for exporters to sell 25% of their foreign-exchange proceeds to the central bank. Inflation expectations have surged amid deeply negative real interest rates.

Room For Nominal Appreciation Is Limited, Even If The Lira Appears Undervalued

After a period of extreme volatility at the end of last year, the lira stabilized at around 13.5 per U.S. dollar in January 2022. By some measures, the Turkish lira appears significantly undervalued. As of December 2021, the real effective exchange rate, that is, the trade-weighted exchange rate adjusted by the difference between inflation in Turkey and that in its trading partners, was almost 50% weaker than its 10-year average, if adjusted by the consumer price index, and 25% weaker if adjusted by the producer price index. Turkey's real exchange rate has been trending down over the last decade, so a 10-year average is not necessarily a good proxy for an equilibrium. Even so, the real exchange rate was around 25% below the trend level in December 2021.

What's more, Turkey's current account was in much stronger shape just before the recent episode of lira depreciation than in August 2018, when a large deficit preceded an abrupt fall in the value of the lira. The 12-month current account deficit has been narrowing, with a surplus recorded over August-September 2021 (see chart 3). However, Turkey's external debt remains high. Pressures on the lira over November-December 2021 likely reflected residents converting Turkish lira to foreign currency. With real rates in deeply negative territory as the Fed is about to start its tightening cycle, the lira may come under renewed pressure. It remains to be seen to what extent the forex-protected Turkish lira deposit scheme will reverse dollarization trends.

Chart 3

Meanwhile, rampant inflation--well above that of Turkey's trading partners--is pushing the real exchange rate up. The gap between the current real exchange rate and its trend level has already narrowed. Assuming policy rates remain at their current levels, a probable scenario would be of real appreciation via high inflation, while in nominal terms, the value of the lira may remain relatively stable for a while, before resuming a gradual slide.

Even With A Stable Lira, We Expect Monthly Inflation To Remain Elevated In The First Half Of 2022

There are several reasons for monthly inflation to remain elevated for at least a few months, even if the lira stays relatively stable. First, the external environment remains inflationary. Global inflation shows no sign of abating, supply chain bottlenecks are taking more time to resolve, and commodity prices are high. Turkey imports a significant amount of intermediate goods--for domestic production and export, and will continue to face pressures from imported inflation. Rising prices for intermediate imports, including energy, coupled with currency depreciation, have pushed producer prices to very high levels of more than 90% in January (see chart 4).

Chart 4

As there tends to be a lag between an increase in producer prices and an increase in consumer prices, upward pressure on consumer prices will likely persist in the coming months. Wage developments also point to continuing price pressures.

Minimum Wage And Salary Hikes Will Support Consumer Demand But Add To Inflationary Pressures

We expect a significant increase in economy-wide wages this year, following a large hike in the minimum wage. Minimum wages play an important role in wage-setting in Turkey's labor market, and a larger increase in the minimum wage tends to be associated with a stronger rise in overall earnings (see chart 5).

Chart 5

We note that Turkey enjoys one of the highest minimum-to-median wage ratios among Organization for Economic Cooperation and Development (OECD) economies (69% as of 2020, versus 55% for the OECD average). At the same time, a significant share of Turkey's workers earn minimum wage.

The gross minimum wage has risen by 40% from January 2022, while income tax and stamp duty for minimum wage earners have been abolished. In net terms, the minimum wage has risen by 50%, the largest hike in decades. It now stands at Turkish lira (TRY) 4,250, around US$310 at the current exchange rate. Salaries for government employees and pensions for civil servants have also been raised. A sharp increase in the minimum wage will exacerbate cost pressures for domestic companies.

Our Forecast For Moderate GDP Growth Remains Unchanged For Now

We have kept our baseline GDP growth forecast for 2022-2024 unchanged for now (see table 1). The uncertainty around our base-case scenario remains very high because of the lack of clarity on Turkey's policy direction. Sharply different scenarios for the lira, interest rates, and ultimately growth are possible.

In our base case, we expect GDP growth to continue at a moderate pace. COVID-19 cases are rising, but we expect the pandemic to have a limited effect on economic activity unless an outbreak disrupts the high tourist season in May-September. Wage growth will support household spending, although given high inflation, real wages are still likely to fall this year. The outlook for credit is uncertain. Even though policy rates have been cut, nominal rates for borrowers have increased, although they still fell in real terms. Credit expansion is still ongoing, especially among state-owned banks. Exports are resilient thanks to strong demand from Turkey's key trading partners, and a more competitive lira will help. Upside risks to our short-term growth forecast include a boost to domestic demand from potentially stronger credit growth, but this may require adjustment later on.

Nevertheless, downside risks to our growth outlook are substantial. Sharp depreciation has strained corporate balance sheets, given the sector's sizable amount of foreign currency-denominated debt. Coupled with ongoing economic volatility and the associated uncertainty, this may undermine investment. The Turkish banking sector seems to have sufficient forex liquidity buffers at the moment, but price and foreign-exchange volatility may pose a risk to financial stability. Even though exporters benefit from the lira's depreciation, their competitiveness is eroded by increasing import costs. More than 70% of Turkish imports consist of intermediate goods, and according to a recent study by the Turkish central bank, components imported directly account for up to 28.5% of Turkish exports in manufacturing. All in all, Turkey's overall macroeconomic trajectory remains highly uncertain.

Table 1

Related Research

• How Prepared Are Emerging Markets For The Upcoming Fed Policy Normalization?, Jan. 27, 2022
• The Federal Open Market Committee's Policy Rocket Heads To The Launchpad, Jan. 26, 2022
• S&P Global Ratings Revises Oil And Natural Gas Price Assumptions For 2022-2024, Jan. 20, 2022

Related External Research

• Inflation Report 2022 – I (Jan. 27, 2022), Central Bank of the Republic of Turkey
• Salih Fendoglu, Mehmet Selman Çolak, Yavuz Selim Hacihasanoglu (2019), "Foreign Currency Debt and the Exchange Rate Pass-Through", Working Paper No: 19/24, Central Bank of the Republic of Turkey