* Basci says lower risk premium gives bank more leeway
* Any rate cuts would be moderate, gradual
* Policy to remain tight until inflation outlook improves
* Two-year bond yield drops to 2014 low, lira firms (Adds Basci quotes, economy minister, analyst comment)
By Behiye Taner
ISTANBUL, April 30 (Reuters) - Turkey’s central bank governor said on Wednesday he saw room for a gradual lowering in interest rates but ruled out a deep cycle of easing, saying policy would remain tight until there was a clear improvement in the inflation outlook.
Erdem Basci said a fall in the risk premium on Turkey, partly following successful but bitterly contested local elections in March, suggested there was some room to lower rates.
Turkey’s two-year benchmark bond yield fell to 9.22 percent - its lowest this year - after Basci’s remarks made at the release of the bank’s quarterly inflation report. The lira firmed to 2.1157 against the dollar.
“There seems to be some room to cut rates due to the fall in the risk premium, but the steps taken should be measured. Rapid steps should not be taken,” Basci said, adding any move should not be seen as the start of an easing cycle.
He said the bank would consider reducing its one-week repo rate of 10 percent, through which it has been providing the bulk of the market’s funding needs in recent months. That has already brought banks’ average cost of borrowing well below its official overnight lending rate of 12 percent.
Prime Minister Tayyip Erdogan, a strident opponent of high borrowing costs, called this month for an emergency rate cut, saying that markets had rallied following the March election and that such a move would encourage investors.
His new economy minister, Nihat Zeybekci, echoed that call on Wednesday, saying interest rates should move to a level that would boost investment and production, although he later described Basci’s comments as “sufficient” and said he did not expect rapid rate cuts.
Erdogan has overseen a decade of rising living standards in Turkey and is keen to maintain his record on the economy ahead of a presidential race in August, in which he is widely expected to stand, and parliamentary polls next year.
Such pressure from the domineering prime minister has raised concerns about the central bank’s independence.
“Central bank credibility is absolutely on the line in Turkey at present,” said Timothy Ash, head of emerging markets research at Standard Bank in London.
“Any quick move now to cut rates would just be seen as the central bank responding to government pressure, pre-presidential election,” he said.
Ash also questioned whether the fall in Turkey’s risk premium was permanent, given two more national elections over the next year, concern about an over-centralisation of power around Erdogan and slow progress on rebalancing a heavily consumption-led economy and gaping current account deficit.
“I don’t think we can say definitively that Turkey is out of the woods yet,” he said.
The central bank raised its mid-point forecast for 2014 year-end inflation to 7.6 percent from a previous forecast of 6.6 percent, well above its target rate of 5 percent, although Basci said he expected inflation to start falling from June.
It left its mid-term inflation target unchanged at 5 percent and forecast the 2015 inflation mid-point at 5 percent as well.
“At this juncture, given the political uncertainty towards the presidential elections, increasing inflation and the uncertainty in global financial markets, the central bank should be extra careful and remain prudent for a long while, in our view,” said ING Bank economist Muammer Komurcuoglu.
“Possibly some easing might be delivered as inflation peaks in May and starts a downtrend thereafter,” he said in a note.
The central bank stunned markets with a sharp rate hike at the end of January, ignoring political pressure as it battled to defend the lira after its fall to record lows. It has repeatedly said since then that monetary policy will remain tight until there is a clear improvement in the outlook for inflation.
“If there is a rate cut, it should not be perceived as part of a series, and to express a time frame for the cut wouldn’t be right,” Basci said.
The lira has recovered from its record low of 2.39 in late January, partly due to the rate hike, the easing of political concerns since Erdogan’s AK Party dominated the March local elections, and the U.S. Fed looking likely to curb its monetary stimulus less quickly than feared.
But risks remain.
Ratings agency Moody’s cut its sovereign outlook on Turkey to negative this month, saying political uncertainty would weigh on the weak points in the economy, while Fitch cuts its growth forecasts for this year and next.
“There is a growing balance of payments constraint on growth. Increased domestic savings would help, a better financial mix, higher foreign investment in particular,” Paul Rawkins, senior director in Fitch’s sovereign group, told a conference on Turkey in London. (Additional reporting by Daren Butler and Ece Toksabay in Istanbul, Ozge Ozbilgin in Ankara and Carolyn Cohn in London; Writing by Nick Tattersall; Editing by Hugh Lawson)