Putin Confronts Financial ‘Waterloo’ Risk to Choke Off Inflation

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As Russia’s central bank prepared to lift interest rates last week, an executive at a top state lender warned policymakers were confronting no less than their “Waterloo” — a battle with inflation whose outcome would prove momentous for the country’s financial institutions and markets.

The eventual hike was double the forecast of most economists, a decision that left Russia with one of the world’s highest rates when adjusted for inflation. It marked the culmination of a shift in official thinking over the risks of a price spiral, according to people familiar with the matter, as looming presidential elections stretch spending commitments already swollen by Russia’s war in Ukraine.

Four steps into a tightening cycle that doubled the key rate to 15% and included an emergency decision in August, the Bank of Russia could cap off the year with an increase of up to a percentage point next month if inflationary risks don’t subside, said the people, who requested anonymity to speak about deliberations that aren’t public.

For President Vladimir Putin, the emerging priorities mean the central bank is getting a free hand with rate increases that are likely to be punitive for businesses and households.

While threatening to inflict a recession on the economy, it’s the price of a war budget engineered for “the task of ensuring victory,” in the words of Finance Minister Anton Siluanov. It’s set to allocate more on the military than toward any other single item next year — a splurge that’s kept the ruble under pressure and briefly pushed it past the symbolic 100 per dollar threshold.

To spell out the risk the central bank faced by hiking rates in October, Dmitriy Pianov — deputy president of Russia’s second-largest lender VTB Bank PJSC — invoked the famous battle that led to Napoleon’s defeat.

“Just as Waterloo determined the fate of Europe, so this meeting will largely determine the destiny of both the financial and banking markets in the rest of 2023 and, above all, in 2024,” he was cited as saying by Russian newspaper RBC.

When asked about it after the rate decision, Governor Elvira Nabiullina smiled as she said that “different metaphors” could apply to a standoff that pits the central bank against its adversary. “We are really determined to fight high inflation,” she said.

The Bank of Russia is staking out a bigger role for itself after a stretch this year when it came under pressure to adopt a more dovish tone and later had to take a backseat to government decisions such as the reimposition of some capital controls.

And even as expenditure already ramped up in 2023, a draft budget from the Finance Ministry expects it to grow by a quarter next year to reach 36.6 trillion rubles ($393 billion).

But with the ruble stabilizing after a surge in October, attention is turning back to inflation, a top concern for Russians. Consumer prices are increasingly coming under strain from record labor shortages and heavy government spending.

In seasonally adjusted terms, price growth has averaged an annualized 12.1% in the third quarter, the central bank estimates, more than doubling from the prior three months. It’s also exceeded 6% on an annual basis to reach the fastest since February.

Out of Sync

Costly outlays on the war and the looming elections are meanwhile getting in the way of coordination between the Finance Ministry and the Bank of Russia, the people familiar said. The disconnect means the central bank is receiving what amounts to a blank check for keeping monetary policy tight over the next six months, they said.

“The authorities now tacitly support the central bank because everyone understands that high inflation will mean political destabilization,” said Oleg Vyugin, a former top central bank and Finance Ministry official.

Alongside the most recent rate decision, the central bank also issued updated forecasts that showed inflation will be faster than anticipated — ending this year in a range of 7%–7.5% — and suggested for the first time that price growth could exceed the 4% target next year.

In response, it’s brought borrowing costs to the highest since April 2022 at the risk of tipping the economy into recession. The central bank expects its key rate to average 12.5%-14.5% next year.

What Bloomberg Economics Says…

“Russia’s central bank is deeply committed to the 1970s Bundesbank playbook — an idea that conservative orthodox monetary policy will help shield its currency and inflation from commodity price shocks and sanctions. With the policy rate at 15%, we will see a contraction in credit growth in the first half of 2024, which is likely to put Russia into a recession. Still facing a choice between a ruble rout and recession, the Bank of Russia will opt for recession.”

—Alexander Isakov, Russia economist.

“All other things being equal, we need a higher key rate to ensure price stability,” Nabiullina said, pointing to a bigger fiscal stimulus than expected by the central bank.

The approach could be “excessively tough,” especially as the impact of the earlier rate hikes has yet to materialize in full, according to Olga Belenkaya, economist at Finam in Moscow.

It’s also a threat for wide segments of the financial market such as unsubsidized mortgages as well as lending to consumers and companies, Belenkaya said. Floating-rate debt accounts for more than 40% of consumer credit, leaving it particularly exposed.

“Imbalances may grow,” Belenkaya said. “Sectors dependent on the budget will be protected, but financing conditions will sharply tighten for industries dependent on market lending.”

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