The Bank of Russia will raise the key rate to prevent pure exchange rate panic

The Bank of Russia on Tuesday, August 15, at an extraordinary meeting of the Board of Directors will raise the key rate, without waiting for the September scheduled meeting. Probably, the only significant purpose of this demonstration is to prevent a possible currency panic associated with the weakening of the ruble in July-August, otherwise the transfer of the exchange rate to prices and the acceleration of inflation expectations in the fall-winter of this year would force the Central Bank to raise it even higher. From the materials of the Bank of Russia it follows that, in its opinion, the observed increase in inflation is almost in its pure form a consequence of the rise in the cost of imports, which the population of the Russian Federation is not going to refuse at all.

An extraordinary meeting of the Board of Directors of the Bank of Russia at the key rate is an infrequent event, especially given the absence in August 2023 of major news that could independently influence monetary policy parameters (MP). Recall that at the last, July meeting of the council, the key rate was raised by 100 points, to 8.5% per annum, above analysts’ expectations, the Central Bank’s forecast was revised, including in terms of inflation (its forecast for 2023-2024 was moderately increased). Fundamentally new data on what is happening with inflation, as of August 14, the Bank of Russia simply could not receive – data on the weekly increase in inflation from Rosstat are considered by the Central Bank only as additional information on the structure and dynamics of the consumer price index, fresh data on inflation expectations from regulator, apparently, could not yet appear, since they are being collected and processed right now.

The only thing that has happened in recent days is the symbolic “crossing” of the ruble against the US dollar at 100 rubles/$.

In itself, it does not have any economic significance, however, symbolic events in the foreign exchange market in themselves can trigger the mechanism of an exchange rate panic. In addition, the continued devaluation of the ruble is able to significantly increase inflation expectations (in the current monetary policy mechanism, in the current situation in the Russian Federation, unanchored expectations can cause a feedback effect), and in itself increase the effect of exchange rate pass-through into prices. On the one hand, changing the parameters of the key rate for the sake of repaying currency volatility is not exactly a conventional action on the part of the Central Bank within the framework of the monetary policy model. However, the Central Bank has few alternatives. “Verbal interventions” in the current tense public atmosphere, primarily due to the circumstances of the Russian military operation in Ukraine, are hardly effective. As for the foreign exchange interventions of the Bank of Russia allowed for such a purpose, problems are possible here, since it is the dollar assets on the balance sheet of the Central Bank that are frozen by US sanctions, yuan interventions are apparently considered undesirable and ineffective, spending dollars owned by the Ministry of Finance for these purposes would require relatively long approvals .

Finally, in such a situation, the increase in the key rate is justified in itself. Recall that one of the analytical problems of the Bank of Russia in recent months (April-July) was the definition of time lags in the “pass-through effect”. The capital account restrictions introduced in 2022 significantly distort normal exchange rates, as do new schemes for the repatriation of foreign exchange earnings. Simply put, the amounts received by Russian players in new markets can travel a complex path through different jurisdictions, and determine when and how the “outgoing” export flow will turn into an “incoming” currency flow (and in what form), mixing in the domestic market with dollars circulating within the Russian economy is difficult. With a high probability, the current devaluation of the Russian ruble was provoked by the relatively late return of funds from oil exports to the jurisdiction of the Russian Federation in March-June 2023, rather due to a decrease in its volumes, rather than prices. In addition, the reduction in the actual dollar revenue in foreign trade in favor of the ruble and yuan makes the dollar market in the Russian Federation very “thin” and volatile, while, according to the tradition of several decades, the exchange rate has been a traditional benchmark for the Russian population, which also participates in shaping inflation expectations .

Domestic political unrest around the course also seems to matter.

The Central Bank’s refusal to intervene in exchange rate formation provoked fierce criticism in August by a number of state propagandists in the blogosphere. On Monday, presidential aide Maxim Oreshkin, in a column for the TASS website, unexpectedly announced the “softness” of the Central Bank’s monetary policy as the reason for the weakening of the ruble. Prior to this, the consolidated, albeit very cautiously expressed, position of the “expanded government” on the exchange rate issue was the desire for the Central Bank to ease the monetary policy and lower the key rate. At the same time, Mr. Oreshkin’s argument in favor of a strong ruble, apparently, in reality coincides with the logic of the Bank of Russia, which, however, due to the chosen model of monetary policy – inflation targeting – comments on the ruble exchange rate quite reluctantly and emphasized neutrally. The presidential aide’s statement suggests that “in the coming months, the current account will recover to the levels of the second half of last year,” which is possible, while the assumption that imports to the Russian Federation will fall under the pressure of the exchange rate differs from the assumptions of the Central Bank in this regard. Finally, nothing is known about the August meetings at the presidential and prime ministerial levels, the moods at which could influence the moods in the Central Bank.

An additional confirmation that the cause of the “exchange rate problem” is precisely in expectations and a self-sustaining mechanism is the July Bulletin of the Central Bank on the structure of inflation, released on Monday. It states: “The accelerated weakening of the ruble provoked an increase in inflationary expectations and an additional activation of demand, which made it possible to accelerate the pass-through of increased import costs into prices. The pressure on car prices was also exerted by the anticipation of the introduction of a recycling fee.”

In other words, we are talking about the mechanism that Alexei Zabotkin, Deputy Chairman of the Central Bank, described last week: a very good state of domestic demand for the current circumstances translates into increased demand for consumer imports, and this, with limited domestic supply, leads to pressure on the exchange rate, and he himself provokes both an increase in inflationary expectations and an increase in domestic prices.

Distortions in exchange rate formation lead to the fact that the pass-through effect either accelerates or stops – in the spring, the Central Bank believed that it had slowed down, in the July inflation bulletin, on the contrary, it was stated that in July the pass-through accelerated greatly.

Given the full rationality of the markets (which exists only in theoretical models), even the readiness of the Central Bank to significantly increase the key rate (the Bank of Russia last week unequivocally said that this was almost inevitable in September based on objective inflation data in August) is enough to devaluation process stopped. Actually, this was demonstrated on Monday, the ruble strengthened above the “fatal” mark of 100 rubles/$ only on the news of an extraordinary meeting of the Central Bank. However, the Bank of Russia obviously cannot help raising the rate at the meeting – the market will perceive this as an independent problem. The only question is how strong a signal-demonstration the board of directors of the Central Bank, part of which should have already gone on vacation, would prefer to send to the markets. On the one hand, the Bank of Russia has no grounds to expect a very strong surge in inflation in 2024 given the weakening of the ruble; the form is very limited (although such an increase, apparently, is able to stop the dynamics of the exchange rate for several weeks). Analysts expect the key rate for August 15 to be from 10% to 13% per annum, the possibility of additional decisions of the Central Bank that are not directly related to the rate is being discussed.

Dmitry Butrin