Interest rate cut despite high inflation: Russian central bank in a dilemma

Status: 04/29/2022 5:46 p.m

Because of the sanctions, Russia is suffering from runaway inflation and a sluggish economy. In order to prevent a recession, the central bank cuts interest rates surprisingly sharply. Does that drive inflation?

By Notker Blechner, tagesschau.de

Hardly anyone in Russia could envy her job at the moment: Elvira Nabiullina heads the Russian central bank. The graceful 58-year-old woman has been assigned to a suicide mission: she must save Russia from state bankruptcy and the increasingly negative consequences of western sanctions. And this without angering President Vladimir Putin.

In doing so, it faces a real dilemma: on the one hand, it has to combat rising inflation and, at the same time, give the ailing economy a boost. If it lowers interest rates, it does help the economy, but increases inflation. If it raises interest rates, it slows down the economy.

Elvira Nabiullina, head of the Russian central bank, has a difficult task.

Image: REUTERS

Surprisingly sharp rate cut

For now, Nabiullina’s top priority seems to be to prop up the economy, which has been weakened by the sanctions. On Friday, the Russian monetary authorities lowered the key interest rate from 17 to 14 percent. Economists had expected a smaller rate hike to 15 percent. At the beginning of April, the central bank had already lowered the key interest rate from 20 to 17 percent. After the start of the Russian invasion of Ukraine at the end of February, she had doubled the key interest rate to 20 percent to prevent the ruble from falling.

According to the government, Russia’s economic growth slowed to 1.6 percent in March. In February, gross domestic product (GDP) increased by 4.3 percent. Because of the Western sanctions, Russia’s economy is likely to slip into recession soon. In the worst-case scenario, the Kremlin is preparing for a contraction in GDP of up to 12.4 percent for the year as a whole.

Severe recession looms for the year as a whole

The economists surveyed by the Russian central bank predict a 9.2 percent decline in the economy. This makes them even more pessimistic than the International Monetary Fund (IMF), which predicts an 8.5 percent economic slump.

Central bank chief Nabiullina calls on the economy to restructure. She cannot live off her financial reserves indefinitely and must now reposition herself. A phase of structural change will have to begin as early as spring and summer, in which companies are supposed to invent new business models. The import and export restrictions and the more complicated logistics in foreign trade are likely to hit the economy hard.

“Manufacturers will have to look for new partners and logistics options or switch to manufacturing products from previous generations,” demands Russia’s probably most powerful woman. The exporters, in turn, would have to look around for new customers. All of this will take time, explained the central banker.

Inflation is likely to rise to 23 percent

Nabiullina justifies the recent interest rate cut by pointing out that the risks of financial instability and higher consumer prices have not increased. However, the central bank conceded that inflation is likely to continue to rise. In April, the inflation rate was 17.6 percent. The monetary authorities expect a rate of 18 to 23 percent for the year as a whole.

All the same, the president of the central bank, who is also highly respected abroad, has achieved one thing: she has stabilized the ruble. At the end of the week, the ruble climbed to its highest level against the euro in more than two years. However, the Russian foreign exchange market has long ceased to function according to purely rational criteria. One reason for the ruble’s strength could be that the Russian central bank has introduced a compulsory exchange into rubles for export earnings.

Default averted for the time being

The next litmus test for Russia’s central bank head is imminent: In a few weeks, Russia could face a technical default if the country can no longer service its bondholders. However, the threatened state bankruptcy on May 4th was just averted. Today the Russian Treasury transferred almost 650 million dollars to the holders of two Russian government bonds.

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