19.10.23 Review

Russian Samovar: In the new economic and fiscal environment, the Central Bank is failing to cool down the economy using conventional methods

At the beginning of autumn, the Russian economy was not just growing, but also received fresh impetus due to the surge in oil prices and export revenues. According to the analysts at the Central Bank, in their latest assessment of the current economic situation, economic activity is hitting record levels. However, this only underscores the fact that combating economic overheating through a sharp increase in the key interest rate is not currently proving possible. Domestic demand is exceeding production capacity. Nonetheless, high inflation expectations and a lack of options when it comes to safeguarding money from devaluation are compelling citizens to maintain their consumer behaviour and make significant purchases, thus continuing to exert pressure on the market. Furthermore, preferential mortgage policies persist. Fiscal policy remains relaxed, with the government showing no intent to curtail military spending, while salaries are on the rise. Manufacturing costs are also on the rise. Under these conditions, the regulator recommends preparing for further tightening of monetary policy and sustaining a high-interest rate for an extended period of time. The only question left is the extent to which the rate will be increased at the upcoming board of directors meeting at the Central Bank in just a week’s time.

Inflation in Russia is accelerating, despite the tightening of fiscal policy, analysts at the Central Bank write in their latest editions of the 'What the Trends Say' bulletin and the 'Regional Economy' report. In September, prices rose by 1.14% compared to the previous month, following a 0.75% increase in August. This translates to annualised rates of 14.6% and 9.4%. Actual annual inflation has reached 6%. For the third consecutive month, food prices have been rising at double-digit annualised rates, with the rising cost of fruit driven by the weakening ruble, vegetables by rising fuel costs, and meat by increased expenses, including growing salaries due to a labour shortage. In the non-food segment, price growth slowed slightly in September, but when seasonally adjusted in annual terms, it still remained in double digits.

After a surge in August, the pace of price increases for electronics and automobiles has slowed down. However, this is likely temporary. Import-dependent retailers, having sold off their stocks, are poised to raise their prices again. Fuel costs have also continued to rise, although by the end of September, following the government's restrictions on gasoline and diesel exports, prices began to decrease. The cost of services has also gone up. In the past few weeks, this growth has been following the trajectory of 2021, according to the authors of the 'What the Trends Say' bulletin. If this growth continues until the end of the year, annual inflation could surpass the current forecast of 6-7%. The Ministry of Economic Development has already raised its inflation forecast to 7.5%.

Rising prices are a consequence of economic overheating. Operational indicators for the dynamics of key economic sectors and survey-based data indicate a continuation of strong GDP growth in the third quarter, even though the economy had already reached its potential level in the second quarter, according to the analysts at the Central Bank. In terms of different industrial sectors, the performances remain diverse, but this heterogeneity is of a different kind now: internal demand from both the state and households has propelled trade and manufacturing, while the extractive sector is stagnating. At the same time, the Central Bank experts note that the economy received a new growth stimulus in September due to the increase in ruble revenues of exporters, which was primarily linked to rising oil prices.

Moreover, there is still active expansion in corporate and retail lending, even though a sharp rate hike should have tempered this. When it comes to corporate lending, companies have been able to set limits on previously approved credit lines, anticipating a renegotiation of terms. In consumer lending, growth is being driven by expectations of high inflation, as people make purchases fearing further price increases. This effect is exacerbated by the fact that it has become more challenging in Russia to protect savings from inflation through currency purchases. In light of these high inflation expectations, even after rate increases, retail lending remains an attractive method for safeguarding future cash inflows from accelerating inflation. As a result, Russians are not altering their consumer behaviour and are continuing to make significant purchases. A second factor is the preservation of preferential lending programs: both the quantity and volume of mortgage loans have reached record levels. Once again, the issue lies in the scarcity of simple and reliable methods to protect money from devaluation.

However, even a change in household consumer behaviour will not lead to an immediate reduction in inflation. The pressures of growing import and labour costs will force companies to gradually pass these costs on to consumers.

Thus, cooling down the economy is proving challenging, especially considering that the current key interest rate of 13% is effectively prohibitive. As Re:Russia has previously discussed, the war and sanctions have led to a distortion of the entire paradigm of Russian economic and fiscal policy. Fiscal policy has been softened, and several mechanisms for rebalancing the macroeconomic situation are operating abnormally. The overheating of the economy is primarily a result of government stimuli. The leadership of the Central Bank has repeatedly pointed out that the best way to address this overheating would be through a reduction in budgetary spending. However, a significant portion of these expenses is connected to the war, and budgetary logic is influenced by military and political priorities. As a result, the Central Bank is left with no choice but to raise the key interest rate.

Over the past ten years, the Central Bank has only raised the interest rate to 13% or higher twice: after the start of the war and at the end of 2014. In both cases, after sharp interest rate hikes (to 20% in March 2022 and to 17% in December 2014), the regulator quickly moved to reduce it. However, the Central Bank analysts are now calling for further rate increases and for maintaining this at a high level for an extended period, likely throughout 2024. The only question that remains is to what level the rate needs to be raised. A minimum necessary step would be to increase it to 15% during the Central Bank's board of directors meeting on October 27, but scenarios in which there is a hike to as high as 17-18% are also possible, as suggested by the MMI Telegram channel.