The Central Bank of Russia (CBR) kept key interest rate unchanged at 7.25% at a monetary policy meeting on June 15, citing this week's government's decision to hike the VAT rate to 20% as the main reason for postponing more monetary easing.

The determination with which the government prepares to finance the spending drive announced by the President Vladimir Putin under latest May Decree has alarmed the inflation-orientated regulator and made the CBR more reluctant to cut the interest rates fast.

Analysts were largely uncertain on which way the central bank would jump until the very last moment, but some argued it could have still opted for a minimal 25bp rate cut as inflation remains at historic lows. Currently the consumer price inflation (CPI) rate is 2.4% -- still well below the CBR’s 4% target rate for the year.

At the beginning of 2018 the CBR was steadily cutting rates as part of a moderate monetary easing policy thanks to inflation’s fall to a post-Soviet record low. But since a new US Treasury Department round of sanctions on April 6 upset these plans analysts are scratching their heads trying to figure out the central bank's next move. 

Now the CBR sees the VAT hike as a direct threat to inflation stability, expected to take effect in 2018 and carry through to 2019.

In the statement accompanying the Hold rate decision, the central bank increased its inflation outlook to 3.5-4% for 2018, warning of a temporary hike to 4-4.5% in 2019. The regulator has now postponed the target of reaching inflation of 4% to 2020.

The Finance Ministry did not expect the VAT hike decision to influence the CBR, as inflation is currently is still way below the target, according to previous statements by the minister Anton Siluanov.

But analysts at Aton Equity agree that, "higher VAT could put pressure on inflation expectations as soon as in 2018, as firms are likely to start raising prices in advance." 

Combined with the recent substantial increase in petrol prices and the sell-off in in EM currencies in recent weeks driven by Fed rate hike, the VAT tax increase "is likely to further support the CBR's conservative approach," Aton commented on June 15. Increases in the cost of petrol at the pumps has been the topic of conversation and president Vladimir Putin spend a full 15mins addressing questions on the topic during his recent annual marathon phone-in.

The analysts forecast that the regulator is "most likely to take a pause in rate cuts, and that the pause could last for several consecutive meetings until the effect on inflation expectations crystallises," while allowing that "rate cuts might continue in autumn, bringing the key rate to 6.75-7% at the end of 2018."

The bank notes that the CBR not only increased its inflation guidance, but also shifted its neutral rate estimate from 6% to 7%, meaning that the CBR now sees that turning the monetary policy stance neutral might be possible by late 2019. 

VTB believes that CBR's estimate of the VAT pass-through to inflation "effectively rules out ‘favourable’ surprise-driven [key interest rate] easing this year." The only potential development powerful enough to alter the current path is a major CPI surprise: for instance, if price growth remains below 3% y/y in the run up to the September meeting, VTB analysts conclude.