Russian Inflation Falls to Record Low 3.3%; August Deflation 0.5%

Unexpectedly for most observers, prices in Russia fell by 0.5% in August, the biggest monthly deflation on record. The August deflation brought the year-on-year inflation down to 3.3%, which also means the record lowest inflation in post-Soviet Russia.

Embarrassing enough, the hefty deflation did not come as a surprise only for the analysts, but also for the Central Bank, who just a few weeks ago predicted that prices would stay flat in August (making wrong crop forecasts based on a cold beginning of summer, while ignoring the record rain that again will deliver a near record harvest). This again should not come as a surprise, because the Russian Central Bank has been consistently wrong with its inflation forecasts since 2014 when the financial turmoil started. In the beginning of 2016, they still predicted double digit annual inflation although the year ended with a record low of 5.4%.

The Central Bank's baffling single-minded policy of inflation targeting 

By reference to its misguided inflation forecasts, the Central Bank has kept its steering rate at absurdly high levels since 2015, way over the running inflation rate. As a result, the Russian economy has been suffocating by the highest level of real interest rate (interest over inflation rate), that any country in the world has suffered from in modern times. The primary real interest (difference between inflation and CB rate) has been at levels of 5% and more, while the actual real interest rate as the difference between lending rates and inflation has been 10% and for most lenders even more. At the same time, Russia’s global competitors enjoy much more humane levels of interests; in the US and EU countries, there is practically no real interest as many corporations lend at 1-2%. At the same time, the Russian CB accuses the Russian companies for neglecting exports, telling that the super high rates are there to teach them a lesson.

The Central Bank motivates its bafflingly high interest rates with its policy of “inflation targeting,” the goal to bring inflation down to 4%. The most ridiculous thing is that, this 4% inflation target was announced in 2013, well ahead of the financial turmoil which started with the sanctions the West imposed in the wake of the Ukrainian coup in 2014 and with the plunge in the oil prices in the same year. The financial mayhem wrought by the totally altered external circumstances, did not affect the Central Bank a bit, they stuck to their guns and kept the inflation target unaltered as if nothing had happened.

With the August inflation reading, it is sure that the CB will meet its target by the end of the year (the accumulated inflation for the calendar year now stands at 1.8%). No doubt, the CB Governor Ms. Nabiullina will now be hailed for taming the inflation, which has been the scourge of Russia for decades. But really, the way it has been done gives no cause for celebration. The whole thing reminds rather of a Stalinist single-minded industrialization strategy, never mind the human suffering and all other considerations, the target to build that dam or churn out so and so many tons of steel must be met.

Ms. Nabiullina would deserve much more credit if she had taken into consideration the absolutely changed economic conditions after 2014 and tempered her ambitions by deferring the goal to achieve her target by a few years. Then instead of squeezing the economy dry in record time, the CB could have allowed a slightly higher inflation by applying slightly more realistic interest rates and then moved forward – over a couple of more years - with a 2% real interest rate instead of the damaging 5%.

The damage of the Central Bank’s harsh interest rate policy and misinformed inflation forecasts have been, fortunately, mitigated by its own miscalculations on many other key parameters. The Russian economy was much more resilient and resourceful than the CB expected; Russia was much less dependent on imports than the CB had guessed and Russia was much more apt at substituting imports thanks to its domestic industry, which was quite a bit more diversified than what the CB thought it was. Therefore, the recession following the financial mayhem and the CB’s policies proved much less severe than generally expected, with a cumulated GDP decline of only 2.3% for the three years of 2014 to 2016.

Did Nabiullina lay a wager with Lagarde?

The CB’s policy has been so bewildering, that we would not be surprised if Ms. Nabiullina would have made a wager with some London and Wall Street bankers, or perhaps with Ms. Lagarde from the IMF, that she can bring down the inflation to 4%.

Whatever wager there could have been, the damage is already done and now the Russian Central Bank has run out of excuses to lower the rates, and now that Ms. Nabiullina has won, we can therefore expect at least 2% (2 percentage points) lower rates within half a year, although we think 3% should be more in order. The lower interest rates in turn will fuel the economy. In our opinion, interest rates are a much stronger driver of Russia’s economy than the usual suspect, the oil price.

Following a 2nd quarter GDP growth of 2.7%, Russia’s minister of economic development, Mr. Oreshkin is expecting full year GDP above 2% this year. We at Awara Accounting (Moscow accounting firm) expect a GDP of 2.4% for 2017. At the same time, Awara has raised its GDP forecast for 2018 to 4%. This is motivated by a host of factors, among them: the lower inflation and the expectation of significantly lower interest rates, which will fuel the economy; 2018 is the year of presidential elections and therefore the severe austerity policies of the Central Bank and the government will be tempered; Russia has gone through 4 years of successful adjustments to new economic realities and therefore 2018 will mean the entrance to a new normal; several of the import substitution programs will start to bear fruit in 2018; Russia has consolidated its geopolitical status and reemerged as a global superpower, which will enhance its economic possibilities.