The Bank of Russia faces the threat of being less independent

The objectives set by the Central Bank come down to the following three points: the transition to the floating exchange rate regime by the end of 2014, the transition to the inflation targeting in the mid-term period, and the reduction of inflation down to 4.5% at 2015 year end and 4% by the end of 2016. In addition, the Draft Guidelines asserts that the specified inflation goals can be achieved without exclusively tightening the monetary policy which might lead to a severe recession. The Bank of Russia considers its current monetary policy as moderately tight.

In our opinion, the general trend of the monetary policy set forth in the Draft Guidelines is good. In particular, in our opinion, the goal of keeping inflation at 4% by the end of 2016 is absolutely justifiable, although it seems to be fairly optimistic in the current situation, in view of likely devaluation of the ruble, supply shock in the food market and inflation inertia. An inflation rate of 5.0–6.5% in 2015 and 4.0–6.0% in 2016 seems realistic to us. In view of this, we see reputational risks for the Central Bank which are related to the announcement of fairly strict inflation benchmarks for each year, instead of the target indicator for the end of the targeting period, without assuming the annual commitments.

Additionally, it is worth noting that in the current macroeconomic and political situation the announced Central Bank's policy may come into collision with the government economic course, making the Bank of Russia be exposed to the threat of losing partially its independence.
Abandoning the policy of active intervention and enhancing the effectiveness of the interest rate management policy is an essential condition for the transition to the inflation targeting. The Bank of Russia has achieved over the past 2-3 years a meaningful progress in turning the interest rate policy into a working instrument which has an impact on the money market. The Central Bank's interest rate band has recently been narrowed while the money market real rate moved fr om abnormally low negative values to a positive level, thereby reflecting the time value of money. At the same time, the issue of the effectiveness of the monetary policy's transmission mechanisms ensuring the translation of changes in the money market rate into fluctuations of interest rates on loans issued to the nonfinancial sector, including long-term loans, still remains to be resolved. the Bank of Russia has discontinued since July 2014 its exchange rate interventions. According to the Draft Guidelines, the Central Bank has no plans to intervene into the pricing in the FX market, except when intervention may be useful to retain sustainability of the financial sector. This approach seems to be reasonable to us.

It's worth noting that the document says nothing about using interventions in order to flatten fluctuations of the exchange rate, although the Central Bank previously took such measures within the limits of the foreign currency trading band. Therefore, the document asserts that the so-called managed floating has been abandoned. This is good from the strategic point of view, except that there is a lim it on the set of instruments which the Central Bank can use in case of currency panic. It cannot be ruled out that in such cases the Central Bank would have to use some additional instruments to stabilize the exchange rate, or resume interventions. We agree that to make its policy efficient the Central Bank shouldn't announce specific parameters or the terms of use of such interventions, however the currency policy key instruments should, in our opinion, be defined.

All in all, in our opinion, the document lacks a well-defined position of the Central Bank on the effect of ruble exchange rate fluctuations and a slide of the nominal exchange rate on the dynamics of inflation (exchange rate pass-through), and there is no assessment of the related risks of failure to achieve the inflation goals set by the monetary authorities.

The Draft Guidelines for the Single State Monetary Policy contains three scenarios for the period of 2015–2017, each providing for low values of GDP growth rate and inflation slowdown. In our opinion, they provide a good general description of the spectrum of the developments that may take place. The Central Bank considers the first scenario as baseline and most likely. Under this scenario GDP would grow at a rate of 1% in 2015 and 1.9% in 2016. Furthermore, the monetary authorities would manage to achieve the objective of reducing inflation to 4% by the end of 2016. The Bank of Russia anticipates that inflation will slow down naturally in 2015–2016 amid economic recession, showdown in lending, depletion of the impact of the factors which contributed mostly to the growth in prices in 2014 (i.e. escalating geopolitical tension, sanctions, and monetary policy tightening in the United States), and a moderately tight monetary policy. Therefore, the monetary authorities presume that they will manage to achieve the set inflation goal, without tightening the monetary policy.
In our opinion, this scenario should be considered optimistic, however it is the second scenario that seems to be more probable. Under this scenario GDP is expected to grow at a rate of 0.9% in 2015 and 1.5% in 2016 respectively. Inflation would stay within a range of 6 to 6.5% in 2015 and 4.5 to 5% in 2016. Therefore, under this scenario the Bank of Russia won't be able to achieve the set inflation goals. It's worth noting that both scenarios show crude oil prices over $100 per barrel. It is only the third scenario that provides for a fall in crude oil prices, in which GDP growth appears to be slower while inflation higher.

The Draft Guidelines mentions new refinancing instruments, including 1-7 day gold swaps, plans of expanding the Lombard list, as well as refinancing secured by non-market assets and state guaranteed investment projects is expected to be continued. The need to use these instruments is related to the fact that the Bank of Russia has used up all the existing possibilities of secured lending to credit institutions, and amid blocked access to external markets the Central Bank remains basically the single source of growth in the money supply in the country. Although a great deal of instruments make the monetary policy more flexible, it can be achieved by making the pursued policy less transparent. In our opinion, the Draft Guidelines lacks a full and detailed perception of the pecking order of monetary policy instruments and sources which will be used to increase the money supply in the economy in the mid and long run perspectives. The Bank of Russia should describe the channels of broadening the monetary base amid the limited availability of assets which could be used as collateral in regular repo operations and the abandonment of printing rubles to buy foreign currency. The monetary authorities should set a strategic goal of building up a well-defined system of a limited number of monetary policy instruments having a well-defined pecking order.

In our opinion, a substantial risk is presented by a mounting conflict between the Central Bank's policy aimed at restraining inflation, and the Russian Government's economic course focusing on higher taxes and economic stimulation and, as consequence, escalation of inflation. These are periods when the monetary authorities' independence is subject to endurance test. The ruble will be effected by the factors such as the economic recovery in the United States and Europe followed by higher interest rates, and maybe crude oil price falling further. The free-floating ruble exchange rate will begin to fall, giving way to growth in prices of imported goods and boosting inflation. If the Bank of Russia adheres to the proclaimed policy, it would have to respond by lifting interest rates, which has an adverse effect on economic growth rates.

This may lead to a stronger political pressure by the Government upon the monetary authorities. This may take various forms. For example, the introduction of a procedure for coordinating the inflation goal with the Government, the development of the Bank of Russia's practice of "priority lines" lending or expanding the scope of the Central Bank's mandate by including economic growth promotion and employment policies into its area of responsibility. These measures will result in that the Bank of Russia will lose a considerable part of its independence and the transition to the inflation targeting will be postponed until later (even until it is possibly fully abandoned).
In general, one can agree with the what is set forth in the Draft Guidelines about projected changes in the monetary management. Within the next few years the Russian economy will be balancing near to a stagflation, this period will therefore be unavoidably tough in terms of the implementation of the monetary policy.

Sergey Drobyshevsky, Doctor of Economics, Director of Research,

Pavel Trunin, Ph.D. in Economics, Director of Center for Macroeconomics and Finance, Gaidar Institute,

Evgeny Goryunov, a researcher, Monetary Policy Department, Gaidar Institute