It is unfortunate that, at a time when the global economy is decelerating and major central banks are taking more aggressive action to boost growth, Russia’s central bank finds it necessary to tighten monetary policy. In mid-September, the Central Bank of Russia boosted its benchmark interest rate by 25 basis points, citing the risk of rising inflation and, importantly, rising expectations of inflation in the marketplace. The inflation problem stems largely from rising food prices, as well as from the freeing of administered prices, but the central bank has noted that this can create expectations of inflation that lead to more inflationary behavior among businesses and workers. The bank sees this as a greater problem than slowing output growth.
There could be a silver lining to this otherwise cloudy situation: Increasing interest rates will boost capital inflows into Russia, causing a rise in asset prices and a boost to wealth. Moreover, such capital flows would have the effect of boosting the value of the Russian ruble, thus reducing import prices and relieving some of the inflationary pressure.
On the other hand, rising interest rates could stifle already weak private sector investment. In addition, a rising currency would hurt the competitiveness of noncommodity exports and, by boosting imports, would damage the trade balance.
The question, of course, is whether the central bank’s rate increase is a one-off action or the start of a new round of monetary policy tightening. Some analysts believe that the central bank has only just begun, and that more rate increases are in the cards. That is because core inflation has lately accelerated from 3.6 percent in April to 5.9 percent in August—above the central bank’s target of 5–6 percent. Moreover, although economic growth recently has slowed largely because of export weakness, domestic demand has remained strong. As a result, there have been considerable wage pressures in a tight labor market. The unemployment rate has fallen from 6.1 percent a year ago to 5.2 percent in August. This was the lowest rate of unemployment recorded since the end of the Soviet Union. Wages, consequently, have risen about 15 percent in the past year.
Why has domestic demand been so strong? First, consumer spending has grown rapidly, in part due to rising real wages and in part due to a rapid increase in consumer leveraging. Second, business investment accelerated due to strong cash flow, especially in the energy sector when energy prices were rising. Third, government spending rose early this year in anticipation of the election in March. The lingering effects of fiscal stimulus remain.
Many of the factors that contributed to strong growth of domestic demand have already begun to reverse, even before the central bank raised interest rates in September. First, the acceleration of inflation has eroded the gain in real income for consumers. In addition, banks have already begun to tighten lending standards for household borrowing. Second, fiscal policy was tightened once the election ended. Stimulus from the government has begun to diminish. Third, investment has begun to decelerate owing to weakening corporate profits. The latter have been hurt by the rapid rise in wages as well as by the weakness of demand in Western Europe.
The end result is that the domestic side of the economy is showing signs of weakness, which will only be exacerbated by the tightening of monetary policy. Thus, Russia appears headed for a slowdown.