By Caitlin Ostroff in London and David Gauthier-Villars in Istanbul

Turkey's currency hit a record low against the dollar Thursday after the country's central bank held interest rates steady despite intensifying pressure to act.

The lira fell 2.1% on Thursday, with $1 buying 7.9792 lira, after the central bank left its key, one-week repo rate at 10.25%, surprising the majority of investors and analysts who anticipated an increase.

For several months, the central bank's main policy rate has been negative when adjusted for inflation, making holding the Turkish lira an unattractive proposition for foreign investors and residents alike. Inflation in Turkey was at 11.75% in September, according to the central bank.

The lira is one of the worst-performing currencies this year and has lost a quarter of its value against the U.S. dollar.

Economists have repeatedly called for Turkey to raise interest rates to compensate for inflation that erodes profits from holding Turkish bonds and stocks and to keep the currency from depreciating further. Instead, Turkey slashed interest rates for much of the year and increased credit to households and businesses. This increased imports at the same time the coronavirus pandemic has hit exports.

Last month, Turkey surprised investors by lifting its key rate to 10.25% from 8.25%. Investors hoped that the central bank would continue along that path following its September meeting, which could inspire confidence for foreign investors to return to the market, said Emre Akcakmak, a portfolio manager at asset manager East Capital.

While it didn't raise rates, the central bank tweaked another policy tool that could be used to drain liquidity from the system -- a type of stealth tightening that may aid in supporting the lira. It increased the upper rate that banks getting loans from the central bank can be charged to 14.75% from 13.25%. In recent weeks, the central bank has pushed banks to facilities that charge higher rates, increasing the average cost of funding to 12.52% Wednesday.

Analysts said the move effectively gave the Turkish central bank more room to raise its average lending rate without formally increasing the benchmark rate.

"It's temporary tightening," said Timothy Ash, senior sovereign strategist covering emerging markets at BlueBay Asset Management. "The market knows it's temporary, and the market wants permanent tightening."

In 2018, the lira crashed after interest rates slipped below inflation, with the currency only stabilizing after the central bank hiked interest rates to 24%. This year, the central bank has sought to limit the depreciation of the lira by selling foreign currencies, from its own reserves and dollars borrowed from domestic banks, and buying the lira. It owes more foreign currency to the banks than it currently has in its coffers.

The central bank has said it has adequate reserves.

Reluctance to formally raise rates, as well as the central bank's erosion of reserves to defend the lira, has spooked foreign investors. About $7.6 billion of foreign money has left the local currency bond market this year, as well as nearly $5.7 billion from Turkish stocks.

(END) Dow Jones Newswires

10-22-20 1205ET