Ben Aris in Moscow -

In 2007, the Central Bank of Russia (CBR) made a definitive change in the way it works: it formally dropped attempts to manage the exchange rate and focused entirely on inflation targeting. Today, in the aftermath of last year's ruble crisis, the bank has in effect been forced to abandon inflation targeting.

Russia suffered hyperinflation in the 1990s (technically defined as inflation above 50% a year), and inflation remains a highly emotive issue in the country. For most of last year inflation was put at the top of the lists of regular Russians' worries, ahead of the conflict in Ukraine, although since the start of this year the economy has overtaken it as real wages began to fall for the first time in more than a decade and unemployment started to tick upwards.

However, the CBR lost control of the situation in December last year when the ruble crashed on the back of tumbling oil prices and the regulator was forced to hike rates by 6.5 percentage points to 17% in one day. The commercial cost of capital rocketed to a growth killing 20-25%. Since then, the CBR has had one task: get interest rates down as fast as possible, because the economy has simply ground to a halt and will stay that way until interest rates are back in single digits. The CBR surprised analysts with a 2pp cut in January, a 1pp cut in March and most recently a 1.5pp cut on April 30, bringing the minimum repo rate to a better, but still high, 12.5%.

Wiggle room

This rush to cut rates raises (and the banks would like to go even faster) poses a number of questions, the first being: won't slashing rates send inflation shooting back up?

In a statement accompanying the last rate cut the CBR said inflation was running at 16.5% as of April 27 and was expected to fall to below 8% in 12 months' time and to 4% in 2017. Economists such as Alfa Bank's Natalia Orlova and Sberbank's Evgeny Gavrilenkov have said that upward pressure on inflation caused by the 50% devaluation of the ruble in December has worked its way through the system faster than expected; the spike in inflation caused by a sharp devaluation usually takes about six months to work its way through an economy, but in Russia's case inflation is thought to have peaked in March instead of April or May. That gives the CBR some wiggle room for faster-than-usual rate cuts. The rate cut was further supported by a rally in the ruble vs the dollar and a partial recovery of oil prices.

Secondly, the governor of the CBR, Elvira Nabiullina, believes inflationary pressure is mainly coming from factors such as soaring food prices (the price of cabbage has tripled) – which are the result of agricultural sanctions imposed by the Kremlin last year on EU and US goods – rather than monetary policy decisions, ie. the cause of the current inflation is something that the CBR has no control over.

The upshot of all this upheaval is that the CBR's inflation targeting policy has gone out the window as it administers a string of cardio-vascular rate cut shocks in an attempt to revive Russia's moribund economy. "The main reason given by the central bank for the [April interest rate] cut was 'lower inflation risks and persistent risks of considerable economy cooling', which reinforces the direction of the monetary policy taken after the CBR's U-turn in January 2015," said Danske Bank in a note. "Since then, the central bank is seriously taking into account economic developments rather than purely targeting inflation."

However, some economists are worried and think that inflation is going to be harder to defeat than the CBR is predicting. "That the current inflation spike to 16.9% year-on-year is transitory is a view shared by the majority of analysts: the effects of exchange rate depreciation and the import ban will evaporate soon," said Alfa bank's Orlova in a note. "However, CBR expectations of single-digit inflation by January 2016 are optimistic, in our view, as year-to-date inflation had already hit 7.5% by the end of the first quarter of 2015 and would have to stay at 0.3% month-on-month for the rest of the year to meet that target. We, on the contrary, expect inflation at 11% for the full year."

Orlova also pours cold water on the CBR's target of 4% inflation in 2017. The market consensus is for inflation of 7% in 2016 and 6% in 2017.

Part of the problem is Russia's election cycle will end up boosting inflation. Usually inflation is brought down partly by slowing nominal wage growth, but Russia goes to the polls to elect a new Duma in 2016 and to (presumably) reaffirm President Vladimir Putin in his job in 2018, and in the past the government has dramatically hiked both public wages and pensions in the run-up to elections. This time round the Kremlin will have to spend heavily to keep the ruling party of United Russia in office; it barely cleared the 50% threshold in parliamentray polls in 2011 and has been losing support steadily since then. 

Splashing money about in the public sector might stem that slide, since about half Russia's population is directly or indirectly dependent on state wage spending, while state social spending accounts for 20% of household incomes, according to Alfa Bank. This will give all give another boost to inflation, burying the central bank's target and its pretence of targetting.