Russia's central bank caught on horns of rate dilemma - to cut or not to cut?

Russia's central bank caught on horns of rate dilemma - to cut or not to cut?
Russian policy rates vs wages, CPI
By Ben Aris in Moscow April 27, 2016

After setting its policy rate at 11% last August, the Central Bank of Russia (CBR) meets again on April 29 to decide whether to cut further and give the economy a shot in the arm, or keep rates on hold to support the goal of bringing inflation down to 4% this year. Analysts are divided on which way the CBR will go.

On the growth front, Russia's economy is not doing as badly as expected, but it is not doing well either. The economy finished 2015 with a 3.7% contraction and was still shrinking in February, albeit at a slower annualised rate of 0.6%.

However, the CBR is doing much better on the inflation front. Russia ended 2015 with a crushing 12.9% consumer price inflation rate but that had fallen to an annualised 7.3% by March, leaving the regulator is on track to meet its 4% target. Indeed, the first few months saw mild deflation in many price categories.

It will be a difficult call to make. High inflation is the main concern of the Russian population who had to suffer the travails of hyperinflation in the early 1990s and never really recovered from the experience. Inflation was also boosted by the oil price collapse and related ruble devaluation shocks of the last two years and that has hurt company profits.

However, the banking sector is being crushed by the high cost of borrowing. The only bank that is making any money at all is the state-owned retail behemoth Sberbank, which reported RUB112bn of income in the first quarter against the entire sector income of RUB109bn ($1.65bn) – in other words Sberbank made all the profits in the sector and the rest of the sector is at best treading water.

Expensive credits means that banks are not lending to anyone and that in turn is crushing investment, which of course kills off any chance for renewed growth. Cutting interest rates will break this vicious circle and allow the economy to grow again, but could come at the cost of  rising inflation.

Opinion is divided over which way the CBR will go. The central bank cut rates five times last year after an emergency hike sent the policy rate from 6.5% to 17% in December 2014 due to the collapse of oil prices that month. But the bank has kept the rate on hold at 11% for the last nine months as the devaluation effects forced up inflation rapidly through to the end of December 2015. Clearly the devaluation-induced bump in prices has worked its way through the system, but the conservatives argue that the CBR should hold rates for another few months to be sure the inflation dragon is completely dead.

Some regulator watchers believe the central bank will err on the side of caution, and point out that the recent rhetoric from the bank has been hawkish. Certainly that was true at the last meeting where the CBR tied its hands by its remarks.

The press release for the March 2016 decision contained the statement: "The Bank of Russia may conduct its moderately tight monetary policy for a more prolonged time than previously planned."

The "previously planned" reference stems from the statement made in the December 2015 forecast revision that said: "As inflation slows down in line with the forecast and on the condition inflation risks recede, the Bank of Russia will continue with a downward revision of its key rate." However, the whole government was wrong-footed by oil prices falling again to fresh lows in January, forcing the Ministry of Finance to revise the entire budget plan. If oil hadn't fallen in January then clearly the CBR would have cut rates by now.

Sticking to the statements is another reason some observers believe the CBR will keep rates on hold: its governor Elvira Nabiullina is trying to build a relationship with the market so her rhetoric will also become an economic management tool: she needs to stick to her promises so that she can alter expectations and affect the economy merely by issuing press releases. Surprise or dramatic rate cuts will undermine this nascent relationship. And on this score it seems that Nabiullina has made a lot of progress.

"The CBR has repeatedly underscored the importance of inflation expectations in its decision making framework and, if anything, what we have learned over the last 12 months is that it really means it – the degree of [the] CBR's attention to not just touching the target but remaining around it for at least some while had been grossly underestimated by both the market and ourselves," Alexander Isakov, chief economist at VTB Capital said in a note on April 27.

But others have argued that the situation in the Russian economy is so dire that this is not the time for niceties and that rate-cutting action is badly needed now. Moreover, with inflation falling fast, the CBR now runs the danger of overshooting its 4% target which is much more expensive, economically speaking, than undershooting it. The Russian central bank has always had a very poor record to hitting its inflation targets, having already missed them for six successive years.

Finally, politics will interfere with the decision. Russia goes to the polls for a general election in September and the Kremlin has already started larding the joint with an increase to the minimum wage, which is a key bench mark that is used to calculate a wide array of social benefits on top of forcing employers to pay more. The social largess that the Kremlin is expected to lavish on the electorate in the coming months could end the fall in inflation, so cutting rates at the start of this process will be inflationary. Better, then, to hold off another month until it becomes clearer how much spending the government is actually going to do.

Moreover, after falling, heavily private sector real wages have also started to rise again in the last two months, which will also fuel inflation and could be taken as a reason to hold rates where they are. However, economists, who are increasingly pouring over Rosstat's numbers and drilling into its methodology, say that it's a mistake to put too much emphasis on the more recent wage numbers.

"Real wage growth was 0.6% y/y and 1.6% y/y in February 2016 and March 2016, respectively, prompted both by disinflation and the acceleration of nominal wage growth to 8.7% and 9.0%," says VTB Capital's Isakov. "Yet we are quite confident that the most recent print will be revised down in the upcoming report, with the first tier data for April, which will be based on a more substantial set of wage data ... We see no reason to assume the Central Bank will miss this point – which is more a statistical artefact than a reflection of underlying labour market dynamics – and, hence expect the regulator to attach less importance to it."