* Turkish lira weakens
* December inflation slightly above forecast
* Stocks decline but outpace emerging market sell-off
By Dasha Afanasieva
ISTANBUL, Jan 3 Turkey's lira weakened on Friday as markets concluded a higher-than-expected inflation reading was not enough to trigger an interest rate hike, with investors remaining uneasy about a festering corruption scandal.
The weakness of the lira and higher-than-expected global oil prices have driven inflation higher in recent months, prompting the central bank in October to raise its inflation forecasts for the full year.
Data on Friday showed inflation was slightly higher than expected in December. The lira rose immediately after the release but as analysts concluded price pressures were still not enough to persuade the central bank to hike rates, gains were erased.
"The mix of (a) weaker (lira), higher rates and higher political risk premium suggests there's a significant downside risk to our 3.5 percent GDP growth forecast for 2014," a note from Bank of America Merrill Lynch said.
"It will be very difficult for (the central bank) CBT to hike rates in a backdrop of weakening domestic demand on the fallout of the political crisis."
Despite sharp falls in the lira, the central bank has declined to increase interest rates for fear of harming growth in the run-up to elections.
The central bank has stuck instead to its unorthodox method of supporting the lira mainly through dollar sales.
It sold $1.2 billion in forex auctions on Monday and Tuesday but returned to its more usual $100 million sales on Thursday.
Having hit record lows in the previous session the lira weakened to 2.1741 from 2.1732 late on Thursday.
The wide-ranging graft probe began with a series of dawn raids and arrests last month and has led to the resignation of three ministers and the dismissal of around 70 police officers.
It has revealed fractures within the AK Party, which has ruled for over a decade, and unnerved investors in the run-up to local and national elections this year, prompting a sharp selloff of Turkish assets.
The main Istanbul stock index was down 0.39 percent at 66,726.26 points but outpaced the main emerging market index which was down 1.03 percent.
"Turkey has been sold off relatively much more than what the macro economy implies because of the added risk from political uncertainty - so today there is not such a hit. Given the election schedule in the next 6 months, the uncertainty will remain until the polls come in," said Erkan Dernek, market strategist at Odeabank.
The AK Party has been in power since a first sweeping election victory in 2002. Prime Minister Tayyip Erdogan has overseen a decade of strong development and growth, though government rhetoric against rate hikes in recent months despite sharp falls in the lira has raised market eyebrows.
Analysts are now entertaining the possibility of a weaker AK Party or even Erdogan's departure from power, resulting in huge uncertainties in the future shape of economic policy.
The yield on Turkey's 10-year benchmark bond was steady at 10.62 percent compared with late on Thursday. (Editing by John Stonestreet)