Heated Stagflation: Which scenario will shape the cooling of the Russian economy?

Decomposition of the military boom

As it did a year ago, in August, Rosstat made significant adjustments to the industrial data for the previous two years. While the agency initially estimated production growth for 2023 at 3.5%, it has now revised that figure to 4.1%. The growth estimate for the first half of 2024 has been raised from 4.4% to 5%. In June, according to the previous estimate, growth compared to June 2023 was 1.9%, but the new estimate puts it at 2.7%. Rosstat estimated July output growth at 3.3% year-on-year. In the manufacturing sector, the growth estimate for 2023 was increased from 7.5% to 8.6%, and for the first six months of 2024 – from 8% to 9% year-on-year.

The government-aligned Centre for Macroeconomic Analysis and Short-Term Forecasting (CMASF) attributes the revision mainly to new data (particularly from micro-enterprises) and the clarification of older data by companies themselves. However, as noted by the Telegram channel MMI, the most significant upward revisions were mainly in industries linked to the military-industrial complex. The role of micro-enterprises in these sectors is likely minimal, but price deflators could be highly distorted due to the non-market nature of pricing. Simply put, if manufacturers make some improvements in the design or equipment of a tank, they may set a price for the state customer that the latter cannot verify. If the price is inflated, then Rosstat's estimate of gross value added will also be inflated.

Therefore, the upwardly revised figures from the statistical agency should be viewed with caution. In essence, the picture of industrial dynamics over the past two years looks like this: industry recovered rapidly after a slump in the first half of 2023, then showed weak growth close to stagnation in the second half, accelerated sharply in the first half of 2024, and began to slow again in June and July.

Industrial output according to Rosstat data, CMASF and HSE estimates, 2021-2024, 100 = monthly average for 2021

Thus, the overall picture is presented by Rosstat (in two versions—revised and old) and CMASF, which adjusts the official data according to its own methods. In the index produced by the Higher School of Economics (Bessonov Index), data from sub-sectors related to the military-industrial complex are deliberately excluded. As a result, its dynamics more accurately reflect the true potential of the economy under given macroeconomic conditions, cleansed of production directly financed by the state and unrelated to the actual needs of the economy. In this case, the picture is somewhat different: industry recovered rapidly in the first half of 2023, dipped slightly by the end of the year, and although there is noticeable growth momentum at the start of 2024, it appears less convincing. Ultimately, industry only reached late 2021 levels by mid-2024, but by July it was already showing signs of slowing down. In this picture, there is no miracle of 'life-giving' sanctions or euphoria from investment activity.

At the same time, the calculations by the Higher School of Economics generally align with the decomposition of industrial growth produced by the Central Bank in its monthly bulletin ‘What The Trends Say’. Here, a sharp divergence between the trajectories of investment and consumer sectors begins in the second half of 2022. The rapid growth of the former group is driven primarily by the most 'heavy' sectors, which the Central Bank defines as 'manufacturing of fabricated metal products, except machinery and equipment,' and 'production of other transport equipment’. The Central Bank notes that these sectors account for 40% of the added value in investment-related industries. Strictly speaking, this includes not only military products but also the manufacturing of large, expensive industrial installations made to order. Therefore, part of the explosive growth in this segment can also be attributed to forced import substitution.

Output of manufacturing industry groups, 2019-2024 (2019 = 100%), seasonally adjusted

In the Central Bank's calculations, the dynamics of consumer sectors are closer to the picture given by HSE's calculations for non-military industries: production showed vigorous recovery in the first half of 2023, returned to pre-war levels by June 2023, stagnated in the second half of the year, and exhibited moderate but significant production growth in the first half of 2024, which was followed by a trend reversal in July.

The long-awaited slowdown and its key drivers

The long-anticipated industrial slowdown, which has been expected for almost a year, became evident in the second half of the summer in all calculations—by Rosstat, CMASF, HSE, and the Central Bank. during the second half of the summer. However, as noted by CMASF experts, ‘it is too early to confirm a full-fledged trend of production decline (given the previous positive dynamics)’. According to Rosstat, industrial production fell by 1.5% in June compared to the previous month, and by 0.8% in July. CMASF experts see a similar dynamic, although with slightly lower numbers.

It should be noted that in recent years, a fairly stable business cycle has emerged in the economy: 'heavy' investment sectors and military-industrial production receive advance funding at the beginning of the year, leading to intensive output growth in the first half, followed by a slowdown. For example, in the 'manufacturing of fabricated metal products,' which can be seen as an indicator of military production, after an 8.5% month-on-month increase in May, CMASF experts recorded a 2.6% m/m decline in June and a 7.2% m/m drop in July. (Meanwhile, the production of computers, electronics, and optical products – also largely driven by military government orders – continues to show a diminishing growth rate.) Therefore, the first factor in the summer slowdown can be attributed to the effect of the military business cycle.

A traditionally negative contribution to industrial dynamics comes from the extractive sector: hydrocarbon extraction fell by 0.3% m/m in July, after a 0.2% m/m decline on average in the second quarter. This trend will continue, as Russia must meet its delayed obligations to OPEC+ to cut production. Additionally, coal mining continued to decline in July (-3.3% m/m after -2.1% in June) due to weak demand from China. Since the start of the war, the extractive sector has predominantly been a stagnation factor in industrial dynamics.

However, beyond this, the Central Bank’s data indicates that in July, output in consumer sectors also slowed down (–1.5% month-on-month). This was expected: production in this sector is pressured by the high key interest rate and the reduction of state support for lending, measures taken to cool the economy and curb inflation. Economic indicators – such as the PMI index from S&P Global and the Central Bank’s business climate indicator – remain in positive territory (meaning that the share of positive assessments exceeds the negative), but they are declining. The business survey from the Institute of Economic Forecasting of the Russian Academy of Sciences ('Sergei Tsukhlo’s survey') shows a decrease in demand for industrial products and an increase in finished goods inventory at enterprises. All of this signals an economic slowdown.

Moreover, some indicators also point to a cooling in consumer activity (the Ministry of Economic Development reports a slowdown in the growth of retail trade turnover and the volume of paid services to the population). The reason for this is the slowdown in retail lending, which is the result of deliberate efforts to reduce inflation. According to the Central Bank, the growth rate of lending fell to 1.4% m/m in July – compared to around 2% m/m in March-June. Simultaneously, high bank interest rates on deposits make savings a more rational strategy for the population.

Is stagflation inevitable?

The main news in the second half of the summer was not just the signs of a slowdown in industry and the economy as a whole, but the fact that, despite these signs, inflation was accelerating.

In July, monthly consumer price growth reached its highest rate since the spring of 2022 – +1.14% month-on-month, according to Rosstat (compared to 0.64% in June and 0.74% in May). Adjusted for seasonality, the Central Bank estimates this equates to an annualised inflation rate of 16.1%. A significant factor in this spike was the one-time indexation of utility tariffs; however, even without this, inflation remains high. The current year-on-year inflation rate for July stood at 9.13%. Inflation expectations continued to rise in both July and August, a trend that has persisted for four months in a row, according to the latest ‘inFOM’ survey (12.4% after 12.1% in July and 11.9% in May). The perceived inflation rate also jumped in August to 15%, up from 14.2% the previous month and 14.4% in June.

A scenario in which the economy slows or stagnates while inflation remains high is stagflation, and economists have been discussing it for several months. High growth in the investment goods sector (the military industry) has increased labour market pressures, leading to rapid wage growth that has spread across the economy amid labour shortages (→ Re:Russia: Incurable Disease). Additional stimulus to consumer demand has come from payments to contract soldiers and their families, which, by our estimates, may account for around 3.5% of total consumer spending (→ Re:Russia: Three Trillion for the Living and the Dead). At the same time, the production of consumer goods has seen much more modest growth. This demand pressure has translated into rising prices. In such a situation, producers can pass on cost increases (such as rising borrowing costs) to consumers.

Central Bank experts, however, express cautious optimism. They believe that the inflation peak has passed (indeed, by the end of August, year-on-year inflation had decreased to 9.02% from 9.13% at the end of July, and the last week of August showed deflation – a slight drop in prices). Consumer demand pressure is easing, while corporate lending (that is, loans to businesses) remains at a healthy level. This leads the authors of the ‘What the Trends Say’ bulletin to conclude that the risks of stagflation have decreased.

Yet, these optimistic assumptions may not come to fruition. The issue is not just that budgetary injections into the economy remain a key pro-inflationary factor—this is mostly accounted for by Central Bank experts. What was unusual in August's economic outlook is that both observed and expected inflation rates rose among respondents with savings. Normally, the opposite trend is seen: their sensitivity to inflation is typically lower than that of poorer individuals without savings. This inversion likely indicates a faster increase in prices in consumer goods sectors tied to imports (either imported directly or with a high import component).

This is not surprising. Problems with payment processing through Chinese banks remain one of the most pressing issues for Russian businesses. In fact, this was a significant part of the discussions behind the optimistic facade of reports at the ongoing Eastern Economic Forum in Vladivostok. The tone of these discussions was quite panicked. Cautious Chinese banks had already stopped working with 'VTB Shanghai' by mid-summer, even before the US threatened foreign banks with sanctions in August for dealing with the overseas subsidiaries of Russian credit organisations. In July, according to Kommersant, up to 80% of payments by Russian businesses in yuan were returned. According to Reuters, the volume of suspended transactions between Russia and China is in the tens of billions of yuan.

The reduction or increased cost of consumer imports is a factor that may not have been fully accounted for in the Central Bank's optimistic forecast, and it could steer the economy back toward stagflation in the non-military sector.

Pro-inflationary stability

In the baseline (positive) scenario outlined by the Central Bank on the 29 August, when it released the 'Key Guidelines for Unified State Monetary Policy for 2025 and the Period of 2026–2027,' the Russian economy is expected to slow down in 2025–2026, with growth rates ranging from 0.5% to 1.5% and 1.0% to 2.0%, respectively, along with a parallel deceleration in inflation. However, the regulator immediately acknowledges that this scenario may not materialise. The Central Bank also considers a less favourable 'pro-inflationary' scenario, which 'assumes a higher share of budget expenditures going towards preferential loan programs, as well as an expansion of protectionist measures aimed at stimulating import substitution.' In this scenario, budget efforts, in addition to defence spending, would also stimulate both consumption and production, leading to the normalisation of relatively high inflation. The Bank of Finland's Institute for Economies in Transition (BOFIT) also points to the likelihood of this scenario, suggesting that new budgetary injections could reverse the trend of economic slowdown.

At a meeting on economic issues with the government on 26 August, Vladimir Putin called for ensuring 'sustainable and long-term growth' of the economy. A few days later, government representatives announced they had revised the forecast for economic growth by the end of the year from +2.8% to +3.9%. Essentially, the government adjusted its forecast for a moderate slowdown to align with Rosstat's revised growth estimates. In its 'Key Guidelines' for the end of 2024, the Central Bank expects GDP growth in the range of 3.5-4%, although earlier in the summer, the forecast was in the 2.5-3.5% range. The low growth figures in the Central Bank’s baseline (positive) scenario, which are seen as a condition for reducing inflation, are clearly not in line with the Kremlin’s ideological goals.

In any case, to understand future economic dynamics, it is important to focus not so much on overall industrial growth rates but on how growth is distributed between the military-investment, extractive, and consumer sectors, as well as on import dynamics, which can either stabilise or destabilise the domestic market.