A lower CBR key rate will ramp up inflation

The current monetary policy shatters confidence in the national currency and the targeting inflation regime. What is a reason for keeping savings in rubles if amid worsening economic conditions in the future the central bank may decide not to follow the set inflation target and allow another acceleration of price growth, devaluing the accumulated savings? The recent price rise and expectations of further growth this year discourage people to accumulate savings in rubles whenever possible.

The central bank perhaps underestimates the inflationary effects of the recent ruble's depreciation. The fall in the ruble's real exchange rate has turned out to be much lower than the long-term equilibrium (real exchange rate – the ratio of consumer prices in economy to the prices of foreign trade partners, factoring in the ruble's nominal exchange rate). The ruble's real exchange rate will equalize in the long run, factoring in crude oil prices, i.e. it tends to get weaker if prices go down and stronger when they go up.

However, the dynamics of inflation and ruble stock quote may differ largely, depending on which monetary policy the central bank is conducting. The Bank of Russia ignores the fact that with high ruble's devaluation, prices of domestically manufactured goods become undervalued vs. prices of imported goods, and consumer demand moves towards domestic equivalents of imported goods, thereby triggering price growth, otherwise the market would simply ran into a deficit.

All this may create a "inflation-devaluation" spiral: higher inflation expectations will sap confidence in the national currency and force the ruble to fall, accelerating price growth, to further fuel inflation expectations and keep the ruble falling.

These, however, are not the main risks arising from the central bank's decision to lower the key rate. Should a scenario of further drastic devaluation be strongly evident, the Bank of Russia would either increase the key rate or intervene into the foreign exchange market, and is likely to succeed in preventing the ruble exchange rate from reaching 80?rubles per U.S. dollar.

The real threat lies in that the fueled inflation expectations and sapped confidence in the ruble can make the nominal rate stabilize around 70?rubles per U.S. dollar and never bounce back. And a big part of this devaluation shock will be translated into a consumer price inflation. Estimates of the effects of the ruble's exchange rate stabilizing around 70?rubles per U.S. dollar and 80?rubles per euro (using the dollar-euro basket as ruble depreciation indicator) show that aggregate inflation in the next three years is expected to be some 40%. The foregoing implies that the Bank of Russia should be focused more on stabilizing inflation expectations and creating preconditions for strengthening the ruble's nominal exchange rate.

Andrey Polbin, a senior researcher

The comments are based on Andrey Polbin's article published on the RBC: "Why will inflation in Russia accelerate"