22.09.23 Review

Free Cheese Melts Into A Mousetrap: the economic euphoria of the beginning of the year has turned into an inflationary spike and will provoke a sharp slowdown in production

The Central Bank's business climate indicator remains at a moderately high level, after reaching its peak in the spring, but largely due to expectations. Meanwhile, the sub-index for production volumes has been in negative territory for two months already. However, the sub-index for assessments of demand has remained positive. This unusual combination suggests that the inertia of overheating, which gripped the Russian economy in the summer, has not yet dissipated. Meanwhile, when it comes to rising selling prices and business costs, assessments have spiked sharply, a phenomenon typically seen during periods of crisis. The entrepreneurial euphoria that was evident in all the surveys this spring was a result of the injection of budgetary funds into the economy amid relatively comfortable monetary policy. The Central Bank, which has raised its key interest rate, fears 'entrenched inflationary expectations' and has stated that the rate will remain high until the economy returns to its natural trajectory. Experts believe that the industrial data for August and even September could still look favourable, but beyond that, an economic slowdown seems almost inevitable.

The August value of the Central Bank's business climate indicator increased slightly from 5.3 to 6.2 points after two months of decline (the survey was conducted in September, but reflected the previous month's assessment of the situation). As previously reported, the anomalously high values of the indicator observed from March to May indicated not just an intense recovery but also the fact that the economy was entering an overheating phase due to the simultaneous influence of three stimuli: substantial budget injections at the beginning of the year, favourable mortgages, and rapid growth in consumer lending. The sub-index for production volumes remained positive (meaning that the number of respondents reporting increased production and service volumes outnumbered those who reported decreases) for five months, from January to June, marking a decade-long record for the Russian economy. The average sub-index value over ten years is -3.7, while the average for the aforementioned six month period is 2.8. This is understandable as, over the past decade, the Russian economy has never experienced such soft fiscal policy with relatively comfortable levels of credit and monetary policy rigidity. However, the period of entrepreneurial euphoria has given way to a surge in inflation, a manifestation of overheating.

Production began to cool off as early as July (-0.79 after 1.98 in June) and continued into August (-0.34). However, the sub-index for demand remains positive (meaning that more companies have reported growth in demand than decline), and this situation is quite rare, as seen in the chart below, indicating that the inertia of overheating has not yet dissipated. Over the next three months, companies expect production growth, indicating a return to the trajectory of rapid growth seen in the spring. Nevertheless, expectations have deteriorated in the automotive retail and manufacturing sectors, where they have already realised the inevitability of price increases following the depreciation of the ruble and the sharp rise in consumer loan rates due to the Central Bank's key rate hike.

Sub-indices of the Central Bank's Business Climate Indicator, 2002–2023

However, the most significant jump can be seen in the assessments of selling price growth (a sharp increase of 5 points) and business costs (up by 7 points). Since March, the selling price index has surged from 11.5 to 20.8 points, and the cost index has risen from 29.3 to 42.5. This is a clear manifestation of overheating: as can be seen in the graph, such price and cost spikes were observed only in the crises of 2008, 2014 and 2022 (immediately after the full-scale invasion).

According to a survey of enterprises conducted by the Gaidar Institute in September, price growth in industry has already started to slow down. However, to assess the economic situation, the Central Bank experts will undoubtedly be waiting for their own survey data, which is much more representative (although some specialists have reservations about its sample, as they believe it over-represents small businesses). Nevertheless, when announcing another increase of the key interest rate on September 15th, the Central Bank's leadership emphasised that it has no intention of lowering it in the foreseeable future.

'Credit activity remained high in both the corporate and retail segments. This is partly due to banks granting loans on previously approved terms and conditions... The large volume of existing state programs for preferential lending, especially in the mortgage market, has somewhat diminished the impact of key rate decisions on the dynamics of lending,' the Central Bank lists the risks in its statement. In essence, this means that, in such conditions, preferential mortgages become particularly attractive, although the Kremlin is counting on their social and political impact and does not want to curtail the program.

In Elvira Nabiullina's commentary, 'budgetary risks' are also mentioned, referring to excessive injections of money into the non-consumable production sector, as well as the possibility of additional import problems. However, the main concern of the Central Bank is that inflationary expectations will become more entrenched, especially the fear that rising prices will not cool down but rather will stimulate consumer activity: the expectation of further price increases may push consumers to continue buying and using even more expensive credit. These concerns expose another characteristic of Russia's post-sanctions economy: citizens have significantly fewer opportunities to hold savings in hard currency.

In one way or another, the comments of most experts are unequivocal. The Central Bank's statement that 'The end of the recovery phase of the Russian economy means that its growth will slow down in the future due to supply-side constraints.' Experts from the Center for Macroeconomic Analysis and Short-term Forecasting (CMASF), which is close to the government, in their September review of the Russian economy has expressed the view that the slowdown in July was just a 'pause.' The Centre for Development at the Higher School of Economics (HSE) offers a similar assessment. August figures may still be favourable, as indicated by the slight increase in the Central Bank's business climate index. However, economists surveyed by Re:Russia believe that the data not only for August but also for September could appear quite decent. However, further slowdown seems almost inevitable. The Russian economy has deviated from the path of balanced growth (partly due to the sharp relaxation of fiscal policy) and must return to it, as the Central Bank has stated.

The values of the business climate indicator consist of the modified difference between the responses ‘the situation has improved’ and ‘the situation has worsened’. The composite indicator is formed from two components — an assessment of the current business climate and an assessment of the expected future business climate. Business executives are asked for their assessments of changes in demand and output at the time of the survey and over a three-month period. Separately, the central bank calculates composite indices for demand and output. The survey covers about 14,000 enterprises across all major sectors of economic activity. Indicators for previous periods are prepared using comprehensive data, taking into account surveys received after the preparation of operational data.