The Central Bank of Russia has raised its key interest rate by 2%. To discuss what this means for the economy, Invest-Foresight spoke with Igor Nikolayev, Chief Research Fellow at the Institute of Economics of the Russian Academy of Sciences.
– The key rate is now 21%. Was the market prepared for such an increase?
– The market expected the rate to rise by precisely this amount. The market was still more prepared for a 1% increase but the probability of a 2% increase was also present.
– What does a two-percentage point increase mean? What does the Central Bank fear?
– The Central Bank is afraid, and it honestly admits this, that inflation will be high. And so far, the regulator has not been able to achieve the target inflation rate of 4%.
The target, of course, remains but the reality is still far from it. And, according to the laws of monetarism, the Central Bank now rightly believes that, by making money more expensive, it will dampen the demand. In turn, this will put pressure on price growth.
So, the Central Bank is now following common laws. But, in my opinion, it still underestimates the fact that, as they say, ‘there is no defense against a club except another club’.
– So, apparently, it’s possible to combat inflation by raising the key rate, but this tactic is fraught with other problems?
– Yes, it is one way to combat inflation. But, at best, what can be achieved is that inflation will be slower. And when we have a fiscal impulse, it will continue. Moreover, as you know, the bill on the federal budget has been passed in the first reading. And the budget expenditure already amounts to a little over 41 trillion rubles. This expenditure, by the way, is almost 9.5% higher than that expected at the end of 2024.
In nominal terms, of course, but if inflation is lower, then real expenditure will increase.
– And what conclusion follows from this?
– The fiscal impulse will continue. Look, the expenditure for us will grow by almost 9.5%. And, according to the current budget that was adopted a year ago, an expenditure cut should occur in 2025 by 7% in nominal terms. And a year later, a budget is being adopted for 2025-2026, and there we already see not a decrease of 7%, but an increase of 9%.
There will be a budgetary impulse, which forms the fundamental basis for inflation. Honestly, it’s extremely challenging for the Central Bank to combat this, and real-world evidence supports this. Looking at 2024, in December 2023, we raised the rate to 16%, with annual inflation at 7.4%. Now, as we near the end of the year, we’re looking at a rate of 21% at best, and inflation will be even higher.
What does this mean? Despite the significant rate increase, inflation has risen and will end this year higher than it was last year.
Why should we expect a different outcome next year if the budgetary impulse continues? It won’t be any different, and inflation will remain high.
– However, this does not mean that the Central Bank is not coordinating its efforts with the government, which is increasing budget expenditures.
– Of course, you can’t put it that way. But the government and the Ministry of Economic Development are focused on fostering economic growth. Both forecasts and various documents indicate that this growth relies on increased demand.
– Does this mean that the fight against inflation and the focus on economic growth are mutually exclusive?
– Exactly! Our budget policy aims to stimulate demand, while monetary policy seeks to limit it. They are in direct conflict.
– So, what should be done in this situation? It’s like the swan, the crayfish, and the pike in the famous fable!
– The swan, the crayfish, and the pike were all pulling in different directions. Here, however, they’re standing on the same path, looking each other in the eye.
– Is it possible to satisfy both the wolves and keep the sheep safe? Can we stimulate economic growth without causing excessive inflation?
– We’ll have to make some trade-offs. It seems to me that, given the clash of these key policies…
You know, let me give you a metaphor. I’m not sure how they teach drivers today, but when we learned on manual transmissions, the key thing when starting was to remember to release the handbrake. Right now, our economy is like a car “on the handbrake.” Yes, it can still move, it shows some growth, but the brake is still on.
– So, what should we do about this handbrake?
– The situation is somewhat of a stalemate. We can’t simply abandon the budget stimulus if we want the economy to grow. Plus, geopolitical factors are pushing for continued budget spending, meaning cuts aren’t likely.
However, the impulse will have to be reduced eventually. By its very nature, it can’t be sustained long-term, as it typically leads to negative consequences, including inflation. Eventually, we will have to scale it back and focus on controlling inflation.
But we can’t stop it right now. However, we must make that decision eventually. The longer the stimulus goes on, the more the economy will struggle to keep up, and it will slow down. In fact, it already is. If we look at indicators from the Central Bank, such as incoming payments and the business climate index, they all point to a slowdown. The regulator itself has acknowledged this, noting the decline in economic growth rates.
– How long do you think this policy will continue?
– We’ll have to wait and see. The fiscal impulse became possible because funding was secured, such as through tax increases. Perhaps other sources of funding will be found. But while we are finding money for the impulse, raising taxes, on the other hand, discourages economic growth and reduces entrepreneurial activity. Additionally, the interest rate itself is putting pressure on the economy, and it will continue to do so.
I believe 20% was the ceiling – the point beyond which we really wouldn’t want to go. But, in the end, we moved beyond that.