By Ezgi Erkoyun and Daren Butler
ISTANBUL (Reuters) - Turkey's central bank unexpectedly hiked interest rates by 500 basis points to 50% on Thursday, citing a deteriorating inflation outlook and pledging to tighten even further if it expects the price situation to worsen significantly.
The hawkish surprise came 10 days before nationwide local elections and was seen by analysts as a signal that the central bank was independent from any political constraints, and determined to tackle inflation that is soaring toward 70%.
In response the lira currency rallied as much as 2% and settled around 31.9 against the dollar, reversing weeks of steady declines, and Turkey's dollar bonds extended a rally.
The rate hike - which outstripped virtually all forecasts - "stunned the market," said Piotr Matys, senior FX analyst at In Touch Capital Markets in London.
"Today's decision is a very strong signal that Governor (Fatih) Karahan, who took over from (Hafize Gaye) Erkan when she unexpectedly resigned, is determined to bring staggeringly high inflation under control," he said.
The bank has now raised its key one-week repo rate by 4,150 basis points from 8.5% since last June, following President Tayyip Erdogan's victory in May elections and U-turn towards greater orthodoxy in economic policy.
The "tight monetary stance will be maintained until a significant and sustained decline in the underlying trend of monthly inflation is observed, and inflation expectations converge to the projected forecast range," it said.
Policy "will be tightened in case a significant and persistent deterioration in inflation is foreseen," it added after the monthly meeting of its monetary policy committee.
Goldman Sachs said central bank's move represents a one-off adjustment to saddle inflation expectations rather than the beginning of another tightening cycle.
To reinforce the tightening move, the central bank also adjusted its policy operational framework, setting the overnight borrowing and lending rates 300 basis points below and above the repo rate.
PRE-ELECTION RATE HIKE
Inflation rose to a higher than expected 67% last month, when the central bank had held rates steady after a sustained string of hikes since June.
While inflation is expected to dip around mid-year, expectations remain stubbornly high. The recent lira slide coupled with declining foreign reserves had raised some expectations of more rate hikes ahead - though not until after the March 31 municipal vote for which Erdogan's AK Party is trying to win back key cities like Istanbul.
In a Reuters poll, 20 of 22 respondents expected the bank to keep the rate steady in March, while the other two forecasted a hike of only 250 basis points. The poll showed however that a strong majority expected it to hike again later this year.
The central bank in recent weeks took other steps to tighten credit including action on reserve requirements, prompting some banks to either reduce loan limits or even stop offering loans. It also raised the maximum rate on credit card cash withdrawals.
Tighter fiscal policy is expected after the coming elections, adding to the rising credit costs and compounding economic pain for Turks after a years-long cost-of-living crisis.
Earlier this month, Finance Minister Mehmet Simsek promised steps to help the central bank reduce inflation. Fiscal stimulus cooled significantly after last year's May general elections but picked up a bit in recent months ahead of this month's vote.
"You can read into this (rate hike) that Simsek and the central bank have the capacity to be more aggressive, upcoming election or not," said Peter Kisler, EM portfolio manager at Trium Capital in London.
Last Friday, the central bank's monthly survey of market participants' expectations showed that Turkey's year-end annual inflation was seen at 44.19%, higher than the bank's own forecast of 36%.