The Central Bank of Russia (CBR) was forced to increase its policy rate by a whopping 350 basis points to 12% during an unscheduled meeting on August 15, the second emergency meeting and the second emergency rate hike, since the war in Ukraine started last February. The dramatic events have led to a welter of speculation that the economy is headed towards a fresh crisis as the rate hike has crystalised Russia’s macroeconomic stability risks, Capital Economics said in a note.

“The decision by Russia’s central bank to increase its policy rate by 350bp, to 12.00%, at an unscheduled meeting today underscores the challenges that policymakers are now facing to maintain macroeconomic stability in an economy that is being distorted by military spending. With President Putin unwilling to curb the government’s war effort, the macro imbalances that have built up are likely to persist. We think the coming months will be characterised by further currency falls, and higher inflation and interest rates,” Liam Peach, an emerging market economist with Capital Economics wrote in a note.

The hike action follows a previous 100bp hike in July. The ruble's depreciation has continued, passing RUB100 to the dollar a day earlier, marking a 30% decline in its value year to date.

In acknowledging the surge in inflation over recent months and the economy's overheating, the central bank's statement has also highlighted a significant risk of inflation overshooting the 4% target for the upcoming year. Ironically, the CBR mentioned reducing the target rate to 3% for the first time, if things went well, only the day before the emergency meeting. Those hopes will now have to be put on the backburner, and probably for several years as a result of the currency crisis.

Based on current indicators, Capital Economics has increased its projected inflation peak this year at between 7.0% and 7.5% year-on-year, at least a full percentage point higher than before the ruble devaluation, with a year-end figure of 5.5% in 2024. Previously, the CBR was predicting that inflation rates would fall to the target rate of 4% in 1H23.

“The central bank is in the position of having to hike interest rates sharply due to a number of large and unfavourable inflation developments that have all come at once. The depreciation of the ruble is the latest concern, but Russia’s economy is dealing with severe demand-supply imbalances more generally. These include a tight labour market and insufficient supply capacity in domestic industry. A lot of this has been caused by the war effort. Mobilisation reduced the labour supply and military spending has ramped up,” says Peach.

An public argument emerged on August 14, a day before the hike, after presidential economics advisor Maxim Oreshkin published an op-ed in TASS accusing CBR governor Elvia Nabiullina of running a “soft monetary policy” (keeping interest rates too low for too long) that caused the ruble to tank. Nabiullina countered the problem was demand was too strong, driven by massive military spending among other things, and that has been made worse by a host of other factors, including rising nominal incomes, a very tight labour market after all the men were sent to the front line, rising capital flight and the negative impact of sanctions on the budget revenues and current account surplus, among other things. Without saying so explicitly Nabiullina was admitting that the economy is seriously out of kilter thanks to the war.

At the same time, as bne IntelliNews has argued that Nabiullina has been engaging in a very unusual, for her, unorthodox adventure where she has at the same time tried to weaken the ruble to create more rubles to close the budget deficit and concurrently fight against inflation. This policy did reduce the deficit which has fallen to 1.8% of GDP in July which is back inside the 2% target for the full year, but in the end the adventure has gone badly wrong and set the economic progress back at least a full year, if not more.

Only a week before the currency crisis, the CBR issued a new monetary policy outlook that argued that Russia’s economy was back on a stable economic trajectory with higher growth expectations of around 2.5% a year the next few years. Indeed, things were going so well that Nabiullina was warning the economy was overheating. Those hopes may also have just been dashed by the rate hike.

“The result is that the government’s budget deficit has blown out this year and the current account surplus – which matters most for Russia’s macroeconomic stability and has a large influence on the ruble – has shrunk to dangerously low levels. In the second quarter 2022 (the first full quarter of the war), the current account surplus surged to $77bn. But in the second quarter this year it was just $9bn. Goods and services exports were down 31% y/y in the second quarter, due in large part to lower energy prices and natural gas export volumes. Meanwhile, goods and services imports rose by 35% y/y owing to very loose fiscal policy and a surge in spending on the military,” says Peach.

Presently, Russia is ensnared in a policy tug-of-war between President Vladimir Putin's military ambitions and the central bank and finance ministry's policy objectives. The intensification of the war effort has exacerbated fiscal, external, and inflationary vulnerabilities within Russia's economy. Policymakers are striving to counteract these pressures to safeguard macroeconomic stability, but as part of that effort have had to adopt contradictory policy objectives like weakening the ruble and boosting growth at the same time as fighting inflation and maintaining price stability.

“In the short term at least, policymakers’ options are limited. Energy exports are ultimately at the mercy of Western sanctions and global oil price developments. There’s little scope for a meaningful rise in the supply capacity of the economy straight away. Sanctions will limit the capital inflows that Russia can attract to shore up the balance of payments. And there’s little ammunition for FX intervention as a large share of FX reserves are frozen. The only thing that policymakers can have some influence over is import demand,” says Peach.

To rein in the economy, curtail imports, enhance budget and current account positions, and combat inflation, Russia necessitates both stricter monetary and fiscal policies. Presently, monetary policy shoulders a significant burden, but its effectiveness is undermined by Nabiullina’s lax fiscal policy, according to Peach, who argues that Nabiullina needs to return to her former ultra conservative policies that have made her so famous.

“Russia needs tighter monetary and fiscal policy to cool the economy, reduce imports, improve the budget and current account positions and tackle inflation. Monetary policy is doing the heavy lifting right now but this won’t be enough while fiscal policy remains so loose. With President Putin seemingly unwilling to curb Russia’s military ambitions, non-war fiscal policy will need to be tightened. While the finance ministry has implemented some tax hikes, it looks unlikely that tightening will take place in any meaningful way before the presidential election next March. A fiscal adjustment will probably have to wait for next year,” says Peach.

The upshot is that the central bank needs to continue the rate hikes, says Peach, who is predicting the benchmark rate will rise another 200bp to reach 14% by the end of this year.

“But even this won’t fundamentally alter the big picture and address the precarious nature of the current account position,” Peach warns. Capital Economics said last month that the past year of war and sanctions has resulted in significant and binding resource constraints in Russia. What is left is an economy that’s now in a very unstable position.

“This very much remains the case. It’s just that these risks are materialising much more quickly than we had thought. The next few months are likely to be characterised by further falls in the ruble, and much higher inflation and interest rates,” Peach concluded.