The Bank of Russia does not rule out a further increase in the key rate. Explaining the decision to raise it from 16% to 18% per annum, Elvira Nabiullina pointed to the threat of recession and stagflation if inflation growth is not reversed in a timely manner. Deputy Chairman of the Central Bank Alexei Zabotkin told Rossiyskaya Gazeta how the regulator’s tough policy will allow the economy to avoid the realization of risks and develop sustainably.

The latest rate decision has caused, to put it mildly, misunderstanding among many. For once, our economy is showing decent growth, and the Central Bank, by raising the rate, is putting a spoke in the wheel, some say. Others remind us that with such growth in government spending, the key rate does not work. What do you say?

Alexey Zabotkin: Our economy today has many urgent priority tasks. This includes structural restructuring and solving problems in the sphere of national defense. Stimulating budget policy facilitates the expansion of production in a number of priority sectors. But additional demand from the public sector in conditions when the reserves of labor and production capacity are practically exhausted means that demand in the rest of the economy should be more restrained.

If demand is not contained in such a situation, companies will compete more aggressively for scarce resources, offering ever higher prices for them. And people, fearing the unfolding of inflation, will run for loans and buy up goods for future use.

The rise in inflation in the second quarter and over the last 12 months as a whole clearly shows how these imbalances are growing. We simply must return the economy to equilibrium. In fact, monetary policy (MP) is like a tightrope walker’s balance beam, which helps maintain balance when other forces tilt it in one direction or another.

The Central Bank has started talking about the threat of recession and stagflation. Explain what this is and how Russia could end up in such a situation if our economy’s growth rates are currently among the highest in the world?

Alexey Zabotkin : Yes, we have been seeing high rates of economic growth for several quarters now. But if until mid-2023 they were accompanied by a moderate rise in prices after their sharp jump in the spring of 2022, then since the second half of last year there has been a repeated acceleration of inflation.

What does this mean? That until mid-2023, economic growth was of a recovery nature and was based on the attraction of previously free resources (production capacity, labor force). But over the past year, the growth in the output of goods and services is associated not only with the progressive expansion of our production capabilities, but also with overheating of demand. This is what the significant increase in inflation signals.

The more significant the overheating, the higher the probability that the pendulum will swing with the same force in the opposite direction. Which will lead to a recession. Timely tightening of monetary policy simultaneously solves the problem of slowing inflation by cooling demand growth and reduces the risk that a much more significant contraction will spontaneously occur.

Could the situation get worse?

Alexey Zabotkin : Our forecast assumes GDP growth in both 2024 and 2025. Yes, growth in 2025 will be more restrained – according to our forecast, 0.5-1.5%. But not because the expansion of production capabilities or, as we say, the potential of the economy will slow down. But only because demand, which “ran ahead” due to the sharp breakthrough of 2023-2024, will “take a break”, that is, stabilize at the high levels achieved. It will stop breaking away more and more and, finally, will give time for production capabilities, capacities, and labor productivity to catch up with it.

How do we know this is happening? By the behavior of inflation itself. Inflation will become low if and only if the gap between demand and production capacity – or, as economists call it, the output gap – disappears.

First, tell us how the rate allows the Central Bank to combat accelerating inflation?

Alexey Zabotkin: By changing the key rate and giving a guideline for how it may change in the future, the Bank of Russia influences all interest rates in the economy. Rates for different terms, for different borrowers, for different depositors, of course, differ from the key rate, because they are determined by financial markets. But the “key” significantly influences everything.

The higher the interest rates in the economy – on deposits, on loans, on bonds – the stronger the motivation to direct additional income to savings and, conversely, the less desire to take out loans. Accordingly, a higher level of rates allows demand to be more moderate. And to more quickly eliminate that very output gap, which is the main reason for accelerating inflation.

By the way, in the conditions of an economic downturn, as it was, for example, at the peak of the pandemic in 2020, we, on the contrary, reduced the rate down to 4.25%. This was necessary to avoid the risk of deflation, support demand, which had fallen sharply at that time, and accelerate the economic recovery. And the rapid reduction of the key rate in the summer of 2022 to 7.50% accelerated the recovery of GDP after the external shock of the spring of that year.

Demand and credits are the key to economic growth, and therefore to increased tax revenues to the treasury. Will the Central Bank’s policy hit the budget?

Alexey Zabotkin: It is important to distinguish between sustainable growth of economic potential and growth of nominal GDP as a result of rapid price growth and high inflation. Both increase tax revenues. But growth of budget revenues as a result of high inflation is an illusory benefit. After all, the state will have to increase all expenses by the amount of inflation.

If this is not done, then the purchasing power of the income of public sector workers will decrease. And in terms of public investments, it will be necessary to either increase estimates (the prices for all materials and work have increased due to high inflation), or reduce the physical volumes of public investments, and abandon some projects.

Only an increase in income associated with the growth of economic potential provides a stable and long-term increase in real budget resources. Monetary and credit policy, which performs a stabilizing function, maintains inflation at a low level. With such inflation, demand grows in line with the expansion of the economy’s potential, that is, our policy does not restrain long-term growth in any way. There is no contradiction with budget policy here.

The Central Bank’s inflation forecast for this year has been raised to 6.5-7.0%. How is this possible if Rosstat already gives more than 9%?

Alexey Zabotkin: The answer to this question requires delving into the arithmetic of calculating annual inflation. It is calculated for a sliding 12 months. What does this mean? The value of more than 9%, which was recorded according to operational weekly data at the beginning of July, after the increase in regulated tariffs, is the increase in prices over the previous 12 months, that is, from July to December 2023 and from January to the beginning of July 2024.

The interval from January to the beginning of July 2024 will also be included in the calculation of annual inflation in December 2024. But instead of July-December 2023, when price growth was very high, the December inflation of this year will include the price growth for July-December 2024.

The significant tightening of the monetary policy has already slowed down price growth in the first half of this year and will slow it down even more in the second half. Accordingly, the annual indicator at the end of the year will be significantly lower than its peak value in early July.

The head of the Central Bank did not rule out a further increase in the rate. Under what conditions could it be raised to 20% and higher?

Alexey Zabotkin : If in the coming months we still have doubts that inflation is slowing down, and the inflation expectations of citizens and businesses are falling sufficiently and at a sufficient speed, so that in 2025 inflation will again be 4%.

Or if additional inflationary risks are realized, for example, a significant deterioration in external conditions, a decline in our exports, or a reduction in the ability to receive imports.

The Central Bank began raising the key rate a year ago, but inflation is not slowing down. What is the reason?

Alexey Zabotkin: The slowdown is gradual. It takes a considerable amount of time for the new interest rate level to affect consumer and business decisions, credit and demand, and, as a result, inflation. This period is 3-6 quarters. Therefore, the main effect of the decisions we made earlier will be fully evident in the second half of 2024 and beyond.

The head of the Central Bank emphasized that the rate will remain high for as long as it takes to slow down inflation. There are already forecasts that you will lower the rate at the end of winter or in the spring. What do you think about these forecasts?

Alexey Zabotkin: Our opinion is reflected in our forecast. It will be appropriate to discuss in more detail the timing of the start of the key rate reduction only when the possibility of its further increase is completely removed from the agenda. For now, as you can judge from the signal from the board of directors, it is premature to talk about this.

People and businesses cannot survive for so long without affordable credit.

Alexey Zabotkin: I would like to emphasize that we do not have the task of stopping lending. The main task of the Bank of Russia is to achieve low inflation across a wide range of consumer goods and services. These are not the same thing.

Our forecast assumes growth in credit, both consumer and corporate, in 2024 and beyond. But this growth should now be more moderate than in 2022-2023, when it was necessary to accelerate the recovery of the economy and its adaptation to sanctions. This was precisely what the rapid rate cut in the summer of 2022 was aimed at.

We see a noticeable slowdown in credit growth in certain segments – market mortgages, corporate loans at fixed rates. However, for inflation to return to 4%, this slowdown needs to become even more noticeable. Both the additional increase in interest rates in recent months and the reduction in the perimeter of preferential lending programs will affect this. It is worth noting that a noticeable increase in rates occurred already in May-June in response to higher inflation and expectations of an increase in the key rate.

Is high inflation really that important if the economic growth rate is also high?

Alexey Zabotkin: The juxtaposition of high economic growth and low inflation is deceptive. Economic growth can be true when it continues at a steady pace year after year. But it can also be imaginary when two or three years of growth are followed by a recession, and ultimately the economy is stuck in place.

What sustainable or true growth will be is determined by the objective capabilities of the economy. That is, the available resources, including labor, and the efficiency of their use, as well as the development of new technologies, structural policy, and the institutional environment.

At high rates of price growth, economic growth will be unsustainable. Why? Because if everyone knows that inflation is high and will remain high for a long time, then depositors and investors will demand higher deposit rates, otherwise they will become poorer. And this will directly translate into high interest rates on loans, as well as bond yields.

The availability of long-term credit will ultimately be less when inflation is high than when it is low. And this will not speed up long-term growth; on the contrary, it will slow it down.

Incidentally, this very misconception – that higher inflation can be exchanged for additional economic growth – was the cause of stagflation in the US and Europe in the 1970s. For Americans and Europeans, it was a difficult time with high unemployment and rising crime, which was reflected, among other things, in popular culture. To suppress inflation, the US had to raise the rate to 20% in the early 80s and go through two recessions within three years.

Many commentators tend to either underestimate or keep silent about the costs of inflation for society and business – both short-term and, especially, long-term. But all world experience shows that it is easy to spin up the flywheel of inflation, but incomparably more difficult to slow it down. Therefore, we repeat that it is impossible to buy sustainable economic growth at the price of high inflation.

What is more beneficial for people with low incomes, such as pensioners?

Alexey Zabotkin : Low inflation, firstly, protects people’s income and savings from depreciation. And, probably, for groups of the population with a more moderate income level this is more important than for wealthier citizens. The latter have a more diverse range of income sources, some of which suffer less from inflation, for example, company shares.

Secondly, as I have already said, low inflation increases the availability of long-term financing. This is important for businesses for investments, and for people, for example, for mortgages. Thirdly, with low inflation and high confidence in the national currency, the efficiency of the Central Bank’s monetary policy is higher. And as a result, the efficiency of our country’s economy as a whole. And this is beneficial to all of us.

Recently Elvira Nabiullina asked the heads of the largest banks whether they would agree to issue cheap loans if the Central Bank dropped the key rate significantly below inflation? They laughed it off, but the question remained – would they or not?

Alexey Zabotkin: They didn’t joke about it. They said that it would be a decision that would be frightening in its irrationality and would call into question the predictability of macroeconomic and financial conditions.

More specifically, a sharp rate cut in conditions of high inflation will automatically make it clear to everyone that the economic authorities don’t care about the purchasing power of the national currency. Citizens will rush to withdraw money from deposits, take out consumer loans and buy goods, since deposit rates will no longer compensate them for future inflation, and future inflation will devalue debts.

Business will also start to accumulate stocks of materials in a frenzy, because they know that the products made from them can be sold at a higher price. All this will push prices up by tens of percent. And in addition to this, everyone will rush to buy foreign currency, the exchange rate will weaken. Long-term lending in national currency will simply disappear, and the financial system will become foreign currency-based due to the unpredictability of future inflation.

All cases of prolonged, persistent high inflation are the result of unreasonably soft monetary policy. The most recent example, which is well known to everyone, is Turkey. Turkish economists at some point decided not to raise the rate to combat rising prices, but, on the contrary, to lower it.

As a result, in 2020, inflation in this country was 15%, in 2021 – already 36%, and in 2022 – 64%. And although the policy vector has changed since mid-2023, the rate has been raised to 50%, annual inflation has not yet fallen below 60%. Monthly price growth has slowed to 2-3% in recent months, but this is still 24-36% on an annualized basis. And the rate still remains 50%.

We now also give mortgages at 22% and more, and consumer loans at 30-40%. Why did the Central Bank push through the abolition of preferential mortgages?

Alexey Zabotkin : The program of broad preferential mortgages at 8% was not cancelled. It expired on July 1 of this year after being extended several times beyond the originally intended, much more limited terms. Our position is that the program of broad preferential mortgages was appropriate only as a short-term temporary measure to support demand for housing during the acute phase of the pandemic in 2020 or at the peak of uncertainty after the shocks of spring 2022.

As a permanent measure, it is not capable of increasing the affordability of housing. When a state subsidy is available to an unlimited number of people, all economic benefits are eventually completely eaten up by rising prices. This, by the way, is true not only for housing, but for any other market.

For example, if the budget decides to give each citizen 10 thousand rubles to buy a refrigerator, then almost immediately the prices for all refrigerators will increase by exactly these same 10 thousand rubles. Simply because each buyer will be ready to pay for the refrigerator as much as his income allowed him, plus these same 10 thousand rubles. The availability of refrigerators will not increase, and budget money will turn into profit for manufacturers. And if they were bought on credit, then into profit for banks.

The same thing happened on the primary housing market – the prices of new buildings additionally increased by the amount of the economic benefit that the preferential interest rate gives citizens. The money that people hoped to save on interest payments was completely “eaten up” by the additional increase in the price of the apartment.

Only targeted assistance to people in need makes sense, and the volumes of such programs should not be of a scale that determines the situation on the housing market as a whole. Only in this case will recipients of this targeted support be able to derive economic benefit from this support. And this applies not only to preferential mortgages, but to any subsidy programs.

The Central Bank keeps saying that it does not target the dollar exchange rate or GDP growth, but only inflation – for the sake of price stability. But is it possible to achieve this without a strong ruble and economic growth?

Alexey Zabotkin: Low inflation is a necessary condition for long-term stability of the exchange rate. If you have a fixed or quasi-fixed rate and high inflation, then sooner or later devaluation will occur. You don’t have to look far for examples – the events of 1998, the crisis of 2008 and 2014 are fresh in most of our memories.

These are clear examples of how high inflation creates serious risks, the main ones being the weakening of the national currency, low confidence in it, chronically high rates and the currencyization of the financial system.

During the period of low inflation in 2017-2019, when it was close to 4%, the ruble exchange rate fluctuated in a fairly wide but unchanged range. This is an illustration that the Central Bank’s focus on price stability simultaneously makes the exchange rate stable. The dynamics of the exchange rate over the past 12 months is another eloquent confirmation of this. The exchange rate is now stronger than it was last summer. And this is a direct result of a tighter monetary policy, interest rates that cover the future inflation expected by the population.

And if we talk about economic growth, the law on the Bank of Russia states that monetary policy should support price stability, including for the formation of conditions for balanced and sustainable economic growth. By maintaining inflation at the target level, the central bank keeps the economy on a trajectory of sustainable growth.

By preventing both prolonged recessions and excessive overheating of the economy, monetary policy makes long-term economic conditions more predictable for individuals and businesses. And low inflation is necessary for moderate interest rates. This also has a beneficial effect on long-term growth rates, although it is not the key determinant of them.

Why was it possible to fix the dollar to ruble exchange rate in the USSR, but in Russia the Central Bank refuses to do this?

Alexey Zabotkin: This is one of those questions that has either a very long or a very short answer. The short answer is because citizens of the USSR were prohibited from owning foreign currency under penalty of criminal punishment. If you don’t have a currency market, then the exchange rate can be set at any rate, whether it reflects economic reality or not.

Despite all the prohibitions, the black market for currency existed even in the USSR. And the ruble rate there was many times weaker than the official fixed rate.

Why don’t banks give people a return on long-term deposits equal to the key rate, although they offer up to 20% or more on short-term deposits?

Alexey Zabotkin: Because as inflation slows, the key rate and other interest rates will also decrease. Loans will become cheaper, which means banks will not be able to provide depositors with the same high returns.

What is the three-year deposit rate? This is the average of the annual deposit rates for each of these three years. Banks assume that, if not today, not tomorrow, then at some point in the future, inflation will be 4%. And this shifts the rates of long-term deposits lower compared to the current level of the key rate.

This is also evident in bond yields – now yields for longer terms are lower than for short ones. Financiers and economists call this phenomenon “yield curve inversion”. It is observed during a period of tight monetary policy. When monetary policy is neutral, and especially soft, then rates for longer terms, on the contrary, will be higher than for short ones.

Sergey Bolotov  / Rossiyskaya Gazeta

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