26.02 Review

Optimism Inflation: Why the Central Bank's business climate indicator gives a distorted picture of economic sentiments

The value of the business climate indicator, which is calculated by the Central Bank based on a large-scale survey of enterprises, continues to indicate an expansion of business activity. However, the growth of the composite index is driven not by current assessments of the actual state of affairs, which have been near zero for over half a year, but by the growth of expectations regarding future production volumes and demand. However, optimism of expectations is characteristic of Russian business regardless of the current situation. Expectations have consistently been higher than current assessments throughout the observation period (since January 2002). In 276 months, the difference between expectations and current estimates was less than 10 points in only nine cases. In the ten years before the war, the difference averaged 15 points. The optimism indicator, measuring the difference between actual assessments and expectations from the average difference between them, appears more informative for assessments of business sentiment, while the current structure of the Central Bank's business climate indicator leads to an inflation of optimism and provides an inaccurate picture of real sentiments.

The second factor leading to distortions in the interpretation of the indicator is related to the extreme unevenness of the economic well-being of different sectors of the economy. The average value of the current assessments index for major sectors, excluding manufacturing, is -2 points. Meanwhile, in manufacturing, it is 5.5, with the anomalous contribution coming from the significantly high index of the investment goods sector (14.5 points), reflecting the effect of militarisation of the Russian economy at the expense of budget funds. Moreover, the tightening of monetary policy has had no effect on it — its average value in recent months is almost the same as in the first half of the year. At the same time, assessments of the current situation in other sectors, and industries in general, show a decline or stagnation associated with the tightening of the Central Bank's policy.

The Business Climate Indicator (BCI), calculated by the Central Bank based on surveys of enterprises, 'indicates continued growth in business activity', the regulator's analysts wrote in the latest enterprise monitoring report. The composite index value remains around 7 points, slightly increasing compared to January. 'There is no evidence that six months of tight monetary policy has led to problems in the economy,' the Telegram channel MMI commented on the situation. This raises the question: is the current monetary policy really tight?

However, the situation seems to be somewhat more complex. The construction of the BCI, as calculated by the Central Bank, leads to a systematic overestimation of the indicator. The extremely useful BCI of the Central Bank is the average of the index of assessments by enterprises of the actual state of affairs and their expectations. The first indicator in the February survey was -0.1 points, after -0.5 points the previous month, and the second was +15 points. Actual assessments of the current situation have remained near zero for seven months. This means that an equal number of businesses said the situation has worsened and improved. Some growth in the composite index is provided not by current assessments but by expectations regarding future production volumes and demand, which increased at the end of the year after a summer decline (10.8 points in the third quarter, now 15). Therefore, it is not particularly accurate to say that the Central Bank's business activity index 'indicates continued growth in economic activity' - it indicates positive expectations with virtually unchanged assessments of the current state of affairs. 

However, expectations are not that straightforward either. Throughout the observation period since January 2002, expectations have exceeded actual assessments on average by 16 points (the median is almost the same). In the years 2002–2005, during the phase of vigorous recovery growth, this difference was 19 points. In the ten years before the war (2012-2021), when the economy was in a phase of low growth, the difference averaged 15 points. The difference fell below 10 points in only nine cases during the 276 months of observation — despite the fact that the Russian economy experienced crises in 2008-2009, 2014-2016, 2020 and 2022. Thus, in isolation, the fact that expectations exceed current estimates tells us little about the current conjuncture. A more informative indicator is the deviation of the difference between actual assessments and expectations from the average difference between them. Such an indicator — the business optimism indicator — will show how much higher or lower the expectations of enterprises are compared to the standard at the moment.

The Central Bank’s Business Climate Indicator and Re:Russia’s Business Optimism Indicator, 2012-2024

As a result, a modified business climate indicator could look like the value of the current assessments indicator plus an optimism index, that is, the value by which the current expectations index exceeds the standard difference between expectations and current assessments. This value would reflect current assessments of the business climate and how much more optimistic or pessimistic, compared to the norm, enterprises are looking ahead. In terms of dynamics, such an indicator has certain differences from the BCI, but its main distinction lies in the realm of public perception. Due to its positive values, the BCI gives the impression that more enterprises assess the situation positively than negatively. However, the modified indicator removes ‘optimism inflation', which, as we can see, does not depend on the current situation. 

The Central Bank’s Business Climate Indicator and Re:Russia’s Modified Business Climate Indicator, 2012-2024

In any case, it is important to note that business expectations for the two years of the war have remained at a relatively low level, exceeding current estimates by 12 points (below the average for the entire observation period and for the 10 years preceding the war). They particularly deteriorated in the summer of last year (+8.5), before recovering to a neutral level by the end of last year and the beginning of this year. The summer dip in optimism was due to the fact that actual estimates of business activity rose in the spring, while expectations were falling. In other words, the sharp improvement in the economy in the spring did not create long-term optimism among businesses. And businesses were correct: by summer, the economy was showing signs of overheating, the ruble depreciated, and the Central Bank had to raise interest rates sharply.

Finally, the situation and conditions in the Russian economy during wartime differ radically across sectors, making it rather pointless to talk about the growth of business activity in the economy as a whole. The average assessment is a reflection not of the general sentiment of Russian business, but of abnormally high values in certain sectors. As seen in the table, there is a decline in business activity (negative values of the current index) in the extraction of minerals and in trade. In the consumer sector of manufacturing, construction, and services, values are near zero. However, in the investment production of manufacturing associated with government orders and defence, abnormally high values can be observed, significantly shifting the overall index upwards.

Central Bank Business Climate Indicator by industry, 2023-2024

In other words, the business climate index is 'elevated' by the investment goods production sector in the manufacturing industry, which operates on government orders and includes production related to the military-industrial complex. This outlier significantly distorts the picture of 'business sentiment' for the economy as a whole. It is not surprising that the sector's well-being is hardly influenced by the Central Bank's interest rate hike. In the first half of 2023, its value was 10.4 points, and over the last six months, after the rate increase (September–February), it remained at 10.3.

When considering the current assessments indicator by sectors, it is evident that the consumer goods processing sector exhibits an unstable weak positive trend, while in the production of intermediate goods, the index has more than halved in the last four months compared to June. A dramatic decrease from 5 to -5 points is observed in extraction, and in construction and services, positive dynamics from March to June (+4 points) have been replaced by near-zero values in recent months. The business climate index in trade has persistently negative values. In other words, if we exclude the manufacturing industry, the economy's response to the interest rate hike is undoubtedly present, although not as dramatic as one might expect in a more market-oriented economy in terms of investment sources.

In light of the above, it is not surprising that a very different picture of business sentiment is painted by an economic survey conducted by independent economist Sergei Tsukhlo (previously conducted while working at the Gaidar Institute). The Industrial Optimism Index calculated by him (referring to changes in sentiments compared to the previous month and expectations for the next two months) decreased for the second consecutive time in February, from +21 points to +14. Sales estimates immediately decreased by 5 points, reaching +2 compared to +7 the previous month. The production plans indicator decreased by 2 points after a 7-point decrease in January. As a result, the value of the index is at its lowest for more than a year. The discrepancy between this and the Central Bank's results is most likely explained by the peculiarities of the samples used in the surveys. Tsukhlo's index apparently represents the military-industrial complex more comprehensively, thus altering the overall picture.