Military Hangover: Russian economy will have to face a recession to achieve disinflation targets
In the first quarter of 2025, Russia’s GDP contracted by approximately 0.5% compared to the final quarter of 2024. It is highly likely that the second quarter will also show negative dynamics. This would indicate that the Russian economy is in recession.
The Russian authorities' hopes for a ‘soft landing’ of the economy are unlikely to materialise. The overheating of the economy in 2023–2024 was too intense and prolonged to be corrected without significant costs.
In recent months, inflation has slowed considerably, but the disinflation trend does not appear to be sustainable.
Inflation expectations are decreasing very slowly, and a key factor restraining inflation is the overvalued rouble. However, given declining export revenues, a devaluation of the rouble is virtually inevitable and necessary for the government to rebalance the budget and reduce the deficit. Such a devaluation will have a pronounced inflationary effect.
Under these conditions, lowering the key interest rate might prevent the economy from sliding into a technical recession, but it would undermine the possibility of achieving disinflation targets.
The core problem does not lie in the interest rate itself, but in the nature of growth over the past two years. The high level of investment activity during this period was largely one-off and illusory, while investment in the non-military sectors of the economy remained low. The decline in export revenues will only worsen this situation.
In the past, Russian economic policy followed a counter-cyclical pattern: during times of high revenue, reserves were accumulated; in leaner times, those reserves were invested into the economy. In 2021–2023, amid high export revenues, the authorities increased fiscal stimulus. Now, with revenues falling, their capacity to support the economy through public spending is nearly exhausted, while conditions for private investment are absent.
Towards recession
In the first quarter of 2025, Russia’s GDP fell by approximately 0.5–0.6% relative to the fourth quarter of 2024, adjusted for seasonality (Raiffeisenbank analysts estimate a 0.5% drop, while Bloomberg Economics chief economist for Russia, Alexander Isakov, estimates a 0.6% decline). If the economy contracts again in the second quarter compared to the first, it can be formally declared in recession, unless Rosstat retrospectively revises previous data substantially, as has happened before(→ Re:Russia: Inflate and Dominate).
In annual terms, the economy grew by 1.4% in the first quarter compared to Q1 2024, following a 4.5% year-on-year rise in Q4 2024 versus Q4 2023, according to Rosstat. This result fell short of the Ministry of Economic Development’s preliminary estimate (+1.7% year-on-year), based on early data. At present, GDP is tracking below the Central Bank’s lower forecast bound, according to the Telegram channel ‘Hard Figures’. In sequential terms (i.e. relative to the previous period), this translates into negative growth.
Re:Russia has long predicted that the overheating of the Russian economy in 2023–2024 would reach such proportions that a return to a natural trajectory would require not merely a slowdown but an actual contraction compared to previous periods. And it won’t be confined to just one quarter. This, however, does not suit the Russian authorities. Vladimir Putin spoke about the need for a 'soft, modest landing' rather than a 'freeze of the economy itself' during a meeting with representatives of Delovaya Rossiya (Business Russia), whose members complained that the high refinancing rate was strangling business. The Ministry of Finance has also cautiously joined the chorus of critics urging the Central Bank to lower the rate, pointing out that both lending and economic growth are slowing down, and suggesting that the Central Bank has 'significant room… in its monetary policy decisions', in plain language, the option to begin cautiously reducing the rate.
The Ministry of Finance has its own serious reasons for nudging the Central Bank in that direction, though of a slightly different nature. A hard landing for the economy, if it comes to pass, would pose a major problem for the Russian budget. As we previously noted, both oil and gas revenues and non-oil and gas revenues were relatively high in the first quarter (→ Re:Russia: Three-way Fork). From the second quarter onwards, the impact of falling oil prices will begin to bite. The authorities hope to offset the decline in oil and gas revenues through a rise in non-oil and gas revenues, with tax hikes introduced specifically for this purpose. However, in the context of an economic contraction, the effect is likely to be the opposite – receipts from VAT and profit tax will begin to fall, at least in real terms. In short, the Ministry of Finance is also concerned about falling GDP, but from a fiscal perspective..
Fleeting disinflation
At first glance, there are some arguments in favour of cutting the key interest rate. Inflation has slowed noticeably: in April, according to Rosstat, prices rose by just 0.4% compared to March. This was lower than the forecasts of both the Central Bank and analysts using weekly data. According to the Telegram channel ‘Hard Figures,’ current inflation rates correspond to 5.5% seasonally adjusted annual rate (SAAR). In other words, if current trends continue for a full year, that’s the inflation rate we would see. This trajectory is even below the Central Bank’s more modest 2025 target to bring annual inflation to 7–8%. By the end of Q1, inflation stood at 8% SAAR, down from 13% in Q4 2024.
However, upon closer inspection, the situation is far from reassuring. While price growth for non-food goods has slowed significantly due to the stronger rouble (1% SAAR in April), prices for food and services continue to rise at a rapid pace (8%), according to Hard Figures. A reduced harvest in 2025 may add further inflationary pressure, the Central Bank warned during its December 2024 key rate meeting. The government also plans to raise utility tariffs.
And it’s not only the Central Bank that doubts the sustainability of disinflation. Inflation expectations among the population are falling slowly and reluctantly. According to a May survey by inFOM, perceived inflation dropped from 16.5% in March to 15.5% in May, but expected inflation began rising again over the past two months (13.4% in May compared to 12.9% in April). At the same time, inflation expectations declined among citizens with savings, who tend to buy durable goods more frequently (from 12.4% to 11.6%), while among citizens without savings, whose spending on food and everyday goods is higher, they rose from 13.9% to as much as 15%. Perceived inflation fell overall, but primarily among savers (from 17.4% to 16.8%), while among those without savings, perceptions barely changed (14% in May versus 14.2% in April).
These insights into inflation perception confirm that the most important disinflationary factor at present is the exchange rate of the rouble, which remains surprisingly strong (83 roubles to the dollar in April). The current exchange rate is the result of a combination of situational factors, notes BCS chief economist Ilya Fedorov. Exporters are currently selling almost all their foreign currency earnings (compared to only half at the end of last year), and in March–April they needed roubles to pay taxes. Demand for roubles is also bolstered by the fact that, due to the stronger exchange rate and falling global oil prices, exporters are receiving fewer compensatory budget payments. Additional foreign currency supply (around $2 billion a month), according to BCS estimates, strengthens the rouble by 3–4 roubles. Companies unwilling to sell foreign currency at the current exchange rate (which they view as a temporary anomaly) are issuing quasi-currency debt instruments (worth $5.2 billion between February and April). If that money had gone towards purchasing foreign currency, the dollar might now cost 2–3 roubles more. Another key factor is the high yield on rouble-denominated assets. Meanwhile, demand for currency remains weak. Total demand for the four months amounted to 275 billion roubles, half as much as a year ago.
However, the situation may soon reverse. The passing of the peak tax payment period will automatically reduce the supply of foreign currency, leading to a weakening of the rouble. As the rouble depreciates, the issuance of quasi-currency bonds will begin to decline. Moreover, the government itself has a vested interest in a weaker rouble. This is a reliable method of rebalancing the budget amid falling export revenues. According to a government source cited by Reuters, the authorities are aiming for a depreciation to around 100 roubles per US dollar – a level at which the budget deficit would not expand excessively. However, a weaker rouble would also drive up rouble-denominated prices for imports, thus becoming an inflationary factor. While a rate of 110–120 roubles per dollar would further ease the budget pressure, the government fears the inflationary impact at that level would be too severe.
In other words, a rate cut at the Central Bank’s next board meeting on 6 June could shift the economy from a recession trajectory to one of stagnation, if not modest growth. However, the Central Bank’s disinflation target of 7–8% for the year would likely not be met in this scenario, and by year-end a surge in inflation could return both the public and policymakers to a state of alarm, as happened in late 2024.
Investment overhang and procyclical policy
Thus, contrary to the authorities' hopes, cooling the economy will likely require not a soft but a fairly hard landing. This is directly linked to the nature of growth over the previous two years. That growth was driven by high investment activity which, however, had a one-off and short-term impact, and was likely partially overstated. Now that further budgetary expansion is no longer feasible, the economy lacks the capacity to sustain current output levels.
Although cumulative investment growth over the first three years of the war reached 25.8% – higher than the 22.4% growth over the previous three years – and the Central Bank sees no signs of a sharp slowdown in 2025, the breakdown of investment activity by the Centre for Macroeconomic Analysis and Short-Term Forecasting (CMASF) leads its experts to conclude that beneath the surface growth lies a weakening of technological modernisation. A significant portion of these investments were technical and forced in nature, and may be overstated due to higher deflators.
For instance, the main contributor to overall investment growth in 2022–2024 was spending on intellectual property assets (+85% over three years), which largely reflected forced costs linked to replacing software from foreign IT firms. These investments likely did not improve, and may even have reduced, enterprise efficiency. Substantial growth in investment in buildings and structures (+44% over three years) was also partly involuntary, replacing westward logistics infrastructure with new systems enabling trade shifts towards the East. Some of it also related to construction work in occupied Ukrainian territories. However, the 'tangible substance' of this construction investment is questionable, CMASF experts note. Construction requires materials, but their supply increased by just 9% over the same period (see → Re:Russia: The Boom Has Gone into Prices for similar conclusions).
Meanwhile, according to CMASF, investment in machinery and equipment by the end of 2024 had at best only returned to 2021 levels at best, and possibly not even that. IIn 2022, investment in this category fell by nearly 10%; in 2023, growth was flat; and recovery only began in 2024. The quality of the machinery and equipment now being purchased is also unclear: Chinese alternatives may be inferior to Western ones, yet costlier due to more expensive logistics and sanctions-related risks, notes Vladimir Salnikov, deputy head of CMASF, in an interview with Monocle. Moreover, much of this investment has gone into expanding military production and thus creates almost no new capacity for domestic consumption or export growth, observes Heli Simola, senior Russia expert at the Bank of Finland Institute for Emerging Economies (BOFIT), in her analysis of the medium-term outlook for the Russian economy. In particular, 'investment' figures have included spending on repairs of Soviet-era military equipment that was later destroyed in combat.
Thus, if we exclude the investment overhang from the military economy and sanctions-related adaptations, both of which were propped up by state spending, Russia’s economy lacks the potential to sustain current output levels. Declining export revenues will only worsen this scenario.
In the face of volatile revenues, the Russian economy has been supported in recent decades by the countercyclical policies of the economic authorities. During periods of high prices, they accumulated reserves, and during periods of falling oil prices, they used them to invest in the economy. However, in 2022–2023, amid war and broad sanctions, the government ramped up fiscal stimulus, building on the export windfall from 2021–2022. This spurred high growth and an overheated economy, triggering an inflationary surge. Now, the situation is reversed: export revenues are falling, government investment capacity is nearly exhausted, and the refinancing rate is already at crisis levels.