22.12.23 Review

Price Dance: What is causing inflation, what dangers does it pose, and how will the inflationary wave in the Russian economy end?

According to the Central Bank's forecast, real inflation for 2023 will be 7.5%, but the current price dynamics suggest that it will be higher. Surveys indicate that both citizens' and businesses' inflation expectations continue to rise.The inflationary wave is a manifestation of economic overheating and is driven by three factors: the growth of enterprise costs, increased demand, and the depreciation of the ruble in the second half of the year. High demand allows companies to transfer cost increases fuelled by the weakening ruble to prices. Prices are rising, but citizens' inflationary expectations are pushing them towards high consumer activity, which in turn allows businesses to raise prices even further. The acceleration of inflation threatens to erode the growth of real incomes, as reported by Rosstat for the results of the first three quarters of 2023. If the inflationary wave does not subside, this may happen as early as the first quarter of 2024. Moreover, income growth has been extremely uneven and is likely to be concentrated in industry, defence and the military sector, while the burden of inflation is spread across the board and is felt particularly acutely by the poorer strata of society. In addition, in a very likely scenario of a sharp slowdown, the Russian economy faces the threat of stagflation, i.e. price growth against a backdrop of stagnation.

Inflation expectations for both citizens and businesses continue to rise, as indicated by the survey data from inFOM and monthly monitoring of enterprises published by the Central Bank this week. InFOM survey data on inflation (capturing its subjective perception) shows that both observed and expected inflation rose by almost 2 percentage points compared to November, reaching 17% and 14.2% respectively (in annual terms). From March to October, the average values of the indicators were 14% and 11%. However, similar values of observed inflation were also recorded at the end of 2021, at the peak of post-COVID recovery when economic growth rates were comparable to the current ones. Nevertheless, such a sharp monthly jump looks unusual and may indicate a high accumulated momentum of the inflation wave.

Real inflation, according to Rosstat, was 7.47% in annual terms in November. According to the forecast of the chief economist of Bloomberg Economics for Russia, Alexander Isakov, it may slightly exceed 7.5% by the end of the year; Vladimir Bessonov, head of the Centre for Development at the Higher School of Economics, expects 8%. However, these forecasts essentially assume a slowdown in the pace of price growth: since June, the value of annual inflation has been increasing on average by 0.8 percentage points each month. If this trend continues throughout the year, inflation will noticeably exceed 8%.

High inflation expectations are of 'serious concern', as stated by Central Bank Governor Elvira Nabiullina at a press conference after raising the key rate to 16%. Due to the high expected inflation, demand in the overheated economy responds poorly to monetary tightening: people keep buying, believing that prices will be even higher in the future, and sellers keep raising prices in response to high demand.

The accelerating inflation in the second half of the year is an indicator of an overheated economy, which was unable to respond to the expansion of solvent demand with an increase in production. Another factor contributing to the rise in prices is the growing costs for enterprises.

According to a Central Bank survey conducted for the December issue of ‘Regional Economy’, 78% of industrial product manufacturers increased their selling prices in 2023. The median estimate of the increase is 6.5%. The businesses surveyed noted that the price increase was mainly a result of rising costs (the median estimate of their increase in 2023 is 11.3%). Regular surveys of the Central Bank's business activity index also show a rapid increase in enterprise costs starting from July-August. Interestingly, the value of this indicator in autumn 2023 was higher than in early 2015, despite the 50% devaluation of the ruble that took place during that period. It can be assumed that this time the effect of the weakening ruble was superimposed on the growth of transport and logistics costs due to the introduction of sanctions and the restructuring of supply chains. However, the sharp strengthening of the ruble at the end of 2022 offset the pressure of these costs for companies, and its significant weakening in the second half of 2023 led to the opposite effect.

Dynamics of price expectations of enterprises, assessments of changes in prices and costs, 2014-2023, balance of responses

At the same time, increased consumer demand allows for the transfer of cost increases to selling prices. These factors continue to be in play, warn experts from the Central Bank in their report on the regional economy. In 2024, according to their data, prices are set to increase for 82% of enterprises, i.e. as much or even more than in 2023. The median level of the expected price increase is slightly lower than in 2023, at 5.5%. 

December monitoring of enterprises records a slight slowdown in the growth of costs in almost all types of activities, except for mining. At the same time, estimates of future demand and production continue to improve in most industries. 'Such business optimism shows that the tightening of monetary policy has not had a noticeable impact on production dynamics: the overheated domestic demand, which allows companies to shift costs to consumers, fully compensates for all the problems,' the MMI Telegram channel has commented on this set of circumstances.

In other words, the optimism of businesses is linked to high demand, which allows them to raise prices and reduce cost pressures. This optimism effect has been reflected in the overall dynamics of the Central Bank's business climate index: it declined in the middle of the year but resumed growth in recent months. At the same time, enterprises' assessments of the current state of affairs have remained almost unchanged, hovering around the zero mark, while the growth of the aggregate index is ensured by the rising expectations of enterprises experiencing the comfort of high demand.

Central Bank Business Climate Indicator, 2020-2023

Meanwhile, business optimism may turn into consumer pessimism. The acceleration of inflation will erode real income growth in 2023. By the end of the third quarter, Rosstat reported growth of 5.1% in annual terms. Although this indicator should be regarded as indicative rather than statistical (as it is based on selective surveys), it should be expected to deteriorate in the fourth quarter due to both the base effect and price growth. In the first quarter of 2024, real incomes may again fall into negative territory, if the inflationary wave subsides slowly, as suggested by the analysts at the Central Bank. 

It is worth noting that income growth in 2023 was clearly uneven. A significant contribution to this growth was made by the growth of salaries and payments of all those associated with the war and the provision of military needs, as well as in the defence sector and in industry as a whole (as a result of the 'spillover' effect of labour shortages in the 'military'). At the same time, the 'inflation tax' is distributed to everyone, and is most acutely felt by the poorer strata of society. Thus, if the population's assessment of observed inflation, according to the Central Bank, is 17%, it appears more like 19% for those who have no savings.

Further, there is a threat that economic growth will slow down sharply due to the exhaustion of the recovery phase and a sharp rise in borrowing costs, while the inflationary wave will still maintain its momentum or will be fuelled further by the weakening of the ruble. In this case, the economy would be at risk of stagflation—a rise in prices amid stagnant output.