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updated 1/29/2014 2:24:33 PM ET 2014-01-29T19:24:33

ISTANBUL (Reuters) - Turkey's central bank hiked all its key interest rates in dramatic fashion at an emergency midnight policy meeting, ignoring opposition from Prime Minister Tayyip Erdogan as it battles to defend the country's crumbling lira currency.

Major Market Indices

The bank raised its overnight lending rate to 12 percent from 7.75 percent, its one-week repo rate to 10 percent from 4.5 percent, and its overnight borrowing rate to 8 percent from 3.5 percent - all much sharper moves than economists had forecast.

A Reuters poll of 31 economists on Monday found a consensus pointing to a 2.25 percentage-point rise in the lending rate. Only one forecast a move this dramatic.

The boldness of the actions stunned investors, sending the lira sharply higher and stirring hopes it would short-circuit a vicious cycle of selling in emerging markets. Asian markets rallied amid a broad revival in risk appetite.

By 0449 GMT the lira traded at 2.166 to the dollar, strengthening further from 2.18 per dollar immediately after the decision, and 2.25 before the bank's action.

The currency has gained almost 4 percent since late on Tuesday and almost 10 percent from Monday's record low of 2.39, in its biggest surge in five years.

Erdogan, keen to maintain economic growth ahead of an election cycle starting in two months, has been a vociferous opponent of higher borrowing costs, railing against what he describes as an "interest rate lobby" of speculators seeking to stifle growth and undermine the economy.

"I would like you to know that as always, I am against a hike in interest rates today," the prime minister told reporters late on Tuesday, hours before the central bank's meeting.

"But of course I don't have the authority to interfere with the central bank ... They are responsible for anything that could arise," he added, emphasizing the bank's independence.

The central bank had been struggling to contain the lira's precipitous slide, with investor confidence damaged by a corruption scandal shaking the government and the global impact of a cut in U.S. monetary stimulus.

Reluctant until now to make an outright rate hike, it had instead tried to defend the currency by burning through forex reserves and trying to squeeze up borrowing costs on the margins - a battle it had clearly been losing and one which it has now decisively abandoned.

In a statement, the bank said it would maintain tight monetary policy until the inflation outlook showed a clear improvement. That could have a marked impact on Turkey's growth, which the government has forecast at 4 percent this year.

"The extremely aggressive nature of the rate hikes is a double-edged sword," said Nicholas Spiro, managing director of Spiro Sovereign Strategy in London.

"It's highly questionable whether Turkey's central bank can maintain such an aggressively tight monetary policy in the face of a sharp slowdown in growth and two major elections later this year," he said.

ELECTION IMPACT

Turkey's problems have been exacerbated by a sharp global emerging selloff in recent days. In a sign of how closely investors are watching worldwide, U.S. stock futures rallied in late trade after the central bank's move, even though a policy decision is due from the Federal Reserve later on Wednesday.

Yet much of the pressure on Turkey is of its own making.

Erdogan has overseen strong economic growth since coming to power in 2002, transforming Turkey's reputation after a series of unstable coalition governments in the 1990s ran into repeated balance of payments problems and economic crises.

But his increasingly authoritarian style - from a heavy-handed police crackdown on street protests last summer to his reaction to the corruption investigation in recent weeks - has started to unnerve investors.

The graft scandal, which triggered the resignation of three government ministers and the detention of businessmen close to Erdogan, has grown into one of the biggest challenges of his 11 years at the helm, just as he prepares for local elections in March and a presidential race he is expected to contest five months later.

His reaction, purging the police force of thousands of officers and seeking tighter control over the courts, has been criticized by the European Union and raised investor concern over the rule of law and independence of state institutions.

It was not clear whether Erdogan, who left on an official visit to Iran before the rate announcement, was informed in advance of its decision.

"This move was all about trying to reestablish the credibility of the central bank, and I think it will go a long way to achieve that," said Timothy Ash, head of emerging markets research at Standard Bank.

"Tightening against a tricky backdrop helps (Central Bank Governor Erdem Basci) win back credibility in the eyes of the market," Ash said.

(Additional reporting by Ayla Jean Yackly and Alexandra Hudson; Writing by Nick Tattersall; editing by Mike Peacock, John Stonestreet)

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