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Update: Turkey central bank raises key interest rate, stems currency selloff

The Central Bank of Turkey said it was raising its late liquidity window interest rate to 16.5% from 13.5%, triggering an immediate reversal of a deep selloff in the country's currency.

The lira, which had fallen more than 5% earlier in the day, rallied to trade at 4.576 to the dollar after the rate hike, before retreating again.

Turkey's currency crisis was exacerbated by President Recep Tayyip Erdogan's comments last week that he might participate in monetary policy decisions.

Erdogan is on record as saying that rising interest rates cause inflation, precisely the opposite of orthodox economic theory. His latest comments caused concern that the central bank would hesitate to raise interest rates even as inflation continued to run at about 10% and Turkey's current account deficit widened.

"It had got so bad after Erdogan's earlier comments on interest rates in London, then the [central bank's] inaction, that people were talking about capital controls in Turkey," Timothy Ash, Senior EM sovereign strategist at BlueBay Asset Management, tweeted after the rates decision.

Fears that foreign investors would flee Turkey seemed to be quelled, though the latest volatility in the currency suggests it is hardly out of the woods.

"Turkey will remain situated in a precarious position and we would not be comfortable suggesting this is the turning point for [the lira] even if we can have a few days of stabilization," Cristian Maggio, head of emerging markets strategy at TD Securities, said in a research note.

The fact that the Turkish central bank has been so slow to react to double-digit inflation will make it even more difficult to curb an overheated economy, especially when the political climate is all about growth, Maggio said in an interview.

The fear is that Erdogan will resort to more fiscal stimulus, which could effectively cancel out the latest rate increase, he said. Last month, the administration announced a corporate tax cut of about 135 billion lira.

Turkish companies have been accustomed to high levels of foreign investment and a partial government backstop if they run into problems. Along the way, many companies piled up debt that may soon be difficult to roll over at a time when the U.S. Federal Reserve is raising rates, Maggio said.

A rate hike like the latest will only win the country "a bit of time," Jan Dehn, the head of research at Ashmore, an emerging markets fund in London, said in an email before the central bank announcement.

The problem is Turkey's "bad macroeconomic policies, which come all the way from the top, i.e., from Erdogan," he wrote.

As of May 22, US$1 was equivalent to 4.65 Turkish lira.

Matei Rosca contributed to this report.