* Rates rise by 125 basis points, more than expected
* Bank says inflation risk still high, more action may be needed
* President Erdogan’s influence on policy has rattled market
* Under-pressure lira gains two percent (Adds Moody’s action on banks)
By Ezgi Erkoyun, Daren Butler and Karin Strohecker
ISTANBUL, June 7 (Reuters) - Turkey’s central bank ramped up its benchmark interest rate to 17.75 percent on Thursday, taking another step to assert its independence, two weeks after an emergency rate hike and just ahead of elections.
Concerns about President Tayyip Erdogan’s growing influence on monetary policy before June 24 polls and doubts over whether the central bank can rein in double-digit inflation have caused the lira to fall some 16 percent this year.
The currency initially rallied some two percent against the dollar after the 125 basis-point increase. Bond yields fell and stocks advanced. The bank has now raised rates by 4.25 percentage points since late May, when it announced a dramatic three percentage-point increase at an emergency meeting to stem the rout in the lira.
“It is quite a positive surprise,” said Kaan Nazli, a senior economist at Neuberger Berman. “That will give (the bank) a lot of credibility after the election.”
Erdogan, a self-proclaimed “enemy of interest rates”, has stepped up pressure on the central bank before the presidential and parliamentary polls. He wants to see lower borrowing costs to spur credit growth and construction.
Economists fear the economy is overheating. The lira’s decline has reflected investor concern about the monetary policy outlook under Erdogan after the election.
Erdogan, who has dominated Turkish politics for a decade and a half, is seen as falling short of a first-round victory, a new poll showed on Thursday, although he has far greater support than his closest challenger.
“The worries will remain that once Erdogan renews his term, he will be more interventionist in terms of central bank policy,” Neuberger Berman’s Nazli said.
“But at least the move today gives the central bank a bit more flexibility to cope with that and at least the starting point will be in a better place than we thought months ago.”
The central bank has also returned to a single policy rate, a move designed to increase transparency. It said on Thursday it stood ready to tighten policy again, if needed, to put a lid on inflation.
“Despite the mild outlook for demand conditions, elevated levels of inflation and inflation expectations continue to pose risks on the pricing behaviour,” the bank said in a statement after its last scheduled monetary policy committee meeting before elections.
Data on Monday showed annual inflation quickened to 12.15 percent in May.
“To our mind, raising interest rates by 125 basis points is a strong hawkish signal that the central bank is fully committed to regain control over inflation by trying to stabilise the lira,” said Piotr Matys, emerging markets forex strategist at Rabobank.
“Over the long-term horizon, what will be crucial is to deal with economic imbalances in Turkey,” he said, citing persistently high inflation and a widening current account deficit.
The bank’s move to a single rate - it had for years used a complex system of multiple rates to set policy - was long sought by investors. Its other rates, including the late liquidity window, are now directly derived from the benchmark rate, meaning policy should be more predictable.
Asset manager Aberdeen Standard Investments, which has $14 billion invested in emerging market debt, said it had increased its exposure to domestic Turkish debt following the rate hike.
“We are definitely more upbeat on the story in light of that move, (it) gives us confidence that policy makers have the upper hand now,” said Kevin Daly, a senior investment manager for emerging market debt.
“How long that lasts remains to be seen, but for the time being these are positive steps and it has given us more confidence in the lira.”
Eleven of 16 economists polled by Reuters had predicted the bank would raise its one-week repo rate, but none had forecast such a large move.
Five each had predicted increases of 50 and 100 basis points and five others no change. One economist predicted a rise of 75 basis points.
Investors will probably want to see the central bank delivering further tightening, if needed, beyond the elections, said Inan Demir, an economist at Nomura International.
“Otherwise, investor sentiment could quickly deteriorate and undermine the currency again,” he said in a note.
Ratings agency Moody’s on Thursday slashed its ratings on 17 Turkish banks, voicing caution about the rising cost of their foreign currency funding.
Last week it placed Turkey’s credit rating - already at non-investment grade - on review for further downgrade, citing concern over economic management and erosion of investor confidence.
The ebbing confidence marks a serious challenge for a country that depends on net capital inflows, it said, adding the authorities were unable to fully address structural economic problems.
Turkey was once seen as a star emerging market for its years of rapid economic growth, but foreign investors have cooled, worried about what they view as Erdogan’s growing authoritarianism.
Following a coup attempt in 2016, some 160,000 people have been detained and dozens of media outlets shut in a crackdown. The government says such measures are necessary because of the security threats it faces.
The lira strengthened to 4.4560 against the dollar after the rate rise from 4.5799 just before. It was trading at 4.4830 at 1605 GMT.
Additional reporting by Ali Kucukgocmen in Istanbul; Writing by David Dolan; Editing by John Stonestreet, Larry King and William Maclean