The Russian economy has enjoyed surprising and rapid growth in the last two years due to massive government cash injections that have given the economy a military Keynesianism boost. But the variables fuelling that boost are now almost exhausted and the economic growth is likely to cool from here on in, Vladislav Inozemtsev, a well-respected commentator who fled Russia after the war started, said in a paper for Riddle.

This growth has been primarily based on underutilised capacity and a reversal of Putinomics: for most of the last decade and a half the Kremlin has run an austerity budget, hoarding money, paying down debt and scrimping on fixed investment; since the war started it has turned on the spending spigots and poured cash into the economy.

With investments concentrated in defence, infrastructure and small and medium-sized enterprises (SMEs), to sustain growth, the government should have kept interest rates relatively low and prioritised continued growth over fighting inflation.

But with so much cash sloshing around the system, coupled with an acute labour shortage that reduced unemployment to a post-Soviet low of 2.6% in July, has stoked inflation, which touched on 9% in July.

The Central Bank of Russia (CBR) has almost lost control of inflation and CBR governor Elvia Nabiullina has been aggressively hiking rates since the first quarter of 2023, putting through another large 200bp hike in July to 18% – close to a ten-year high. More hikes are on the cards before the end of year, unless inflation stalls.

“The Central Bank's decision to curb inflation at all costs could lead to an economic slowdown by 2025, potentially increasing public dissatisfaction with the economic consequences of the ongoing war and sanctions,” says Inozemtsev. “The outcome will depend on the Central Bank's flexibility in monetary policy and its ability to navigate the challenges posed by war, sanctions and fluctuating demand.”

Nabiullina commented on this decision, stating that "for the first time in the last ten years, Russia is experiencing a cyclical overheating of the economy, and a long period of high interest rates is needed to cool demand."

This announcement contrasts sharply with the majority of Western experts and politicians who argue that sanctions are working and the Russian economy is faltering, says Inozemtsev, who disagrees. He argues that most of the military Keynesianism boosts the economy has received in the last two years have been exhausted and the exception growth Russia has enjoyed will start to slow from here.

“The Russian economy, which had grown unnaturally fast in recent years on the back of a multi-channel – but mainly government-initiated – cash injection, has used up its positive effect by mid-2024,” Inozemtsev says.

Unpinning Russia’s growth is the rapid rise in aggregate demand from both the government and the population in the last two years. Between 2021 and 2024, budget expenditures increased by over RUB12 trillion ($82bn), equivalent to 7% of GDP.

Real income growth reappeared for the first time in years, with a 5.4% increase last year and a 7.8% rise in real wages this year. Additionally, capital outflow significantly decreased, partly due to Russians acquiring credit cards from banks in "friendly countries" but spending domestically. And oligarchs have repatriated large amounts of money to keep them out of the hands of would-be sanctioners. The Central Bank contributed to this trend by increasing the money supply by 19-22% per year in 2022-2023, partly by purchasing frozen assets from the National Welfare Fund.

This surge in demand resulted in price increases across various sectors, particularly those replacing lost foreign services, such as hotels, domestic tourism and air transport. This increase in demand appears substantial and not merely short-term.

However, the Central Bank's decision came at a time when several factors contributing to the economy's overheating had already been exhausted. Each of the main demand drivers peaked by mid-2024.

Military spending: The primary sources of aggregate demand growth from 2022-2024 included a substantial rise in military spending, amounting to nearly RUB11 trillion over three years. This spending stimulated demand for military production and related industries, alongside substantial payments to contract workers and mobilised military personnel, estimated at around RUB3 trillion since the war's inception.

But spending is already being cut. The draft three-year budget does not forecast an increase in "defence" spending for 2025 and 2026, and standard allowances for contractors are set to remain unchanged. Despite reports of increased lump-sum bonuses for contract conclusions in certain regions, the overall increase in payments to contractors has slowed, reducing their impact on economic growth.

Housing: Government programmes to stimulate housing demand with subsidised mortgages and issued approximately RUB4 trillion in soft loans from 2022 to 2024, with buyers investing up to RUB1.5 trillion of their funds.

But the government's ended the housing mortgage subsidy programme on July 1, triggering a buying frenzy while the cheap mortgages were still available; a record number of loans issued in the first half of 2024.

Now construction sector is already feeling the impact of the decision, with no new housing delivery records expected in 2024, and a decline in residential real estate prices anticipated after significant rises due to the subsidy programme.

Artificially cooling the housing market and construction business will act as a powerful non-monetary policy tool to cool the economy, but it is a very blunt instrument.

Wages: Wage growth has been very strong with nominal wages rising much more quickly than inflation, delivering the biggest increase in real disposable incomes of 9.6% year on year in a decade in July.

Entrepreneurs have been forced to compete with military production for qualified workers, and wages rose responding to labour shortages due to emigration, the remote employment ban and reduced foreign worker inflow.

Nominal wage growth, which peaked at 12.9% y/y in early 2024, is now expected to slow. The official forecast for nominal wage growth in 2024 is now 6.5%, significantly lower than last year's figure. This deceleration is anticipated to continue into 2025, reducing wage pressure on the consumer market. Additionally, an increase in personal income tax for high-income groups in 2025 is likely to slow the growth of disposable income further.

Import substitution: The substitution for imports, particularly in the service sector, also contributed to economic activity, evidenced by booms in domestic tourism, catering, entertainment and transportation.

But import substitution has only been partially successful and is maxing out. After Putin introduced tit-for-tat sanction on EU exports of agricultural products in 2014, Russia famously created a domestic cheese industry more or less from scratch in about two years, as European cheese used to be better and cheaper. But technology sanctions have limited the scope of import substitution and after two years what could be replaced has been.

The rapid growth of SMEs, driven by import substitution and a service sector boom in 2022-2023, is slowing, as evidence by the latest services PMI, which is hovering around the no-change mark.

Price increases for services, particularly in the hotel sector, have outpaced official inflation rates, and this trend may not continue. Slowing wage growth and tighter credit conditions will likely reduce demand for services and related products, affecting the hiring of seasonal workers and production efficiency improvements.

These developments create a sense of uncertainty about the future course of the Russian economy.

"All resources in Russian economy are exhausted. Inflation is rising, Extreme lack of the workforce. Adding money from reserves to market will just increase inflation without bringing new growth. Russia is likely facing stagnation or deep recession", said Nabiullina said on July 29.

Nabiullina is now trying to engineer a soft landing. In one scenario, as predicted by the Central Bank, involves a collapse of imports, a sharp economic slowdown, and stagnation of real wages and investment activity. This would require maintaining tight credit policies and additional measures to reduce public demand, such as demobilisation or reduced state defence orders.

Another scenario suggests a moderate slowdown, with GDP growth reducing from 4.1-4.3% in 2024 to 2.2-2.3% in 2025, and a gradual reduction in real wage growth to 3-3.5% and real income growth to 2%.

Either scenario would allow the Central Bank to consider lowering interest rates by spring 2025, possibly after another rate hike this year. The currency market is expected to adapt to the new exchange rate formation mechanism, with foreign trade settlements gradually stabilising through cryptocurrencies which are being developed now and direct settlements.