CBR Hikes Key Rate to 12% at Emergency Bank Meeting
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Bottom Line: Central Bank of Russia (CBR) announced on August 15 that it decided to hike the key rate by 350 bps to 12% as ruble tumbled recently, reaching over 101.7 against the dollar as of August 14, which is the weakest in almost 17 months and as the currency lost 30% of its value this year. (Note: CBR raised the key rate by 100 bps to 9.5%, only 3 weeks ago on July 21). We think major reasons behind the bank’s extraordinary reaction have been not only weakening currency, but also the elevated inflation expectations, demand-cost pressures in addition to risks posed by the war and sanctions. Considering that CBR is actively aiming to cool off inflation via key rate hikes, we think this can suppress demand and imports and squeeze lending in the upcoming quarters, but this will take time. We forecast that the rises in the key rate will continue in the remainder of 2023, taking into account that inflation will likely bite harder, while inflationary expectations and currency volatility are predicted to remain strong. We now foresee the policy rate at 14% by end 2023.
Figure 1: CPI (%, YoY), January 2021 - July 2023
Source: CBR, Rosstat
As high domestic demand and lending, strong military spending (which is estimated to be more than $100bn in 2023, a third of all public expenditure)in addition to aggravation of staff shortages fanned inflation this year, CBR’s decisions were under the spotlights for a while. Putin’s economic adviser, Maxim Oreshkin, recently penned an op-ed and mentioned that “The main source of ruble weakening and accelerating inflation is soft monetary policy, and the central bank has all the tools to normalize the situation in the near future.” CBR emergency rate decision came after Oreshkin’s criticism.
We think there are various reasons behind ruble’s recent fall in addition to factors mentioned above. Russia abandoned its budget rule last week, as CBR halted the finance ministry's FX purchases (previously used to try to reduce volatility), but this has failed to stabilize the currency. We believe that the fall in the ruble accelerated as of July as the currency weakened to 90 on July 10, particularly due to Wagner Group’s mutiny on June 23 as the Wagner forces marched through Moscow and took control of military facilities in two Russian cities. The shrinking current account surplus is also hurting sentiment.
As specified by the Monetary Policy Report published on July 31, CBR said it started monetary tightening as the economy has struggled since the ruble has weakened swiftly, domestic demand and lending spiked, the prices for stable components increased, inflation expectations surged and government spending remained high due to war-related military expenses. Within the same direction, CBR said in its written statement on August 15 that “steady growth in domestic demand surpassing the capacity to expand output amplifies the underlying inflationary pressure and has impact on the ruble’s exchange rate dynamics through elevated demand for imports. Consequently, the pass-through of the ruble’s depreciation to prices is gaining momentum and inflation expectations are on the rise.”
We feel CBR’s main concern would remain as the upward trend in inflation in 2023, which also ignited currency to tumble. The demand from the government remained high in the first half of the year, while consumer demand also notably grew due to the surges in the wages and consumer confidence. Buoyant domestic demand has also revived a recovery in imports which triggered the Ruble to lose value. In addition to demand reviving imports, Russian exports continue to shrink recently due to sanctions and low foreign demand. CBR announced on July 25 that exports declined in Q2 owing to a drop in global commodity prices, while a lower physical volume of supplies due to external restrictions and a slowdown in global economic growth also made negative contributions. Taking into account that government spending remained high due to war-related military expenses, this triggers inflation to soar as well. (Note: January-July budget deficit amounted to around approximately $29 billion due to large spending).
In line with these developments, we predicted that further hikes in the policy rates are most likely in 2023, as strongly signaled by CBR in June and July. We also underlined that further tighter monetary policy is required to curb the inflation further considering inflation may quickly deviate from the target in the current framework. It appears our predictions were right, but unexpectedly lower than what Kremlin was hoping for.
We believe that the tightening process and higher policy rates will encourage banks to slow loan growth by adjusting their credit and deposit rates and in turn slow private consumption and limit imports, but this will take time. A weaker ruble might help the authorities to fund the country’s war spending but this will be limited and they do not appear to want a chronically weak ruble. The percentage of further key rate increases will depend on how significantly incoming currency and CPI data will affect bank’s estimate of the developments. Thus, we expect CBR to continue hiking the rate by 200 bps more in the remainder of the year to further restrain the accelerating phase of inflation and tumbling ruble. We now think end year rate will be 14%.