The interest hike of 125 basis points on Thursday sent the country's key lending rate to 17.75 percent, stemming weeks of capital flight that caused the Turkish currency to fall to multi-year lows recently.

Read more: Will Turks heed Erdogan's calls to sell dollars and buy liras?

The massive increase helped the lira gain almost two percent in exchange rate value against the US dollar to 4.47, and 1.3 percent against the euro to 5.29.

"Despite the mild outlook for demand conditions, elevated levels of inflation and inflation expectations continue to pose risks on pricing behavior," the Turkish central bank said, adding that a tight stance in monetary policy would be "maintained decisively until inflation outlook displays a significant improvement."

The decision came three days after an inflation report showed consumer prices rose 12.15 percent in May from a year earlier. Core inflation, which strips highly volatile food and energy prices out of inflation calculations, was the worst on record.

The bank has now hiked rates by 4.25 percent in just over two weeks, following a three-percent increase at an emergency meeting last month.

Surprise

Investors had been expecting a second rate hike between 50 and 100 basis points at most.

Piotr Matys, emerging markets forex strategist at Rabobank, described the decision as a strongly hawkish signal. "The central bank is fully committed to regain control over inflation by trying to stabilize the lira," he said in a note to investors.

And Nigel Rendell, a senior analyst for EMEA at Medley Global Advisors, hopes that the rate hike is "the start of a new era," with Turkish central bank policy aiming to move ahead of the markets.

"Positive impact on the lira is seen as the repo rate rises. How things develop on both the policy front and for the lira longer-term will depend on events after the June 24 elections, and whether Erdogan gives the CBRT latitude to act independently," he said.

Asserting independence

The lira sell-off and subsequently stronger inflation has reflected widening investor concerns about President Tayyip Erdogan's influence on monetary policy.

Erdogan has described himself as an "enemy of interest rates," and has stepped up pressure on the bank ahead of elections to cut borrowing costs in order to spur credit growth and construction.

Read more: Turkey's low-interest time bomb

As a result, ratings agency Moody's last week placed Turkey's credit, which is already at non-investment grade, on review for a downgrade, citing concern over economic management and erosion of investor confidence.

Given that Turkey was deeply dependent on net capital inflows, Moody's said, falling investor confidence marked a significant challenge, especially since authorities seemed "unable to fully address structural economic problems."

The central bank's decisive move could therefore be seen as an attempt to regain credibility after strong criticism in recent months had accused it of reacting too late and too little to market developments.

uhe/nz (Reuters, dpa, AFP)