12 01 2025

How (not) to control inflation in Russia

Inflation is high in Russia and people are worried that butter prices have gone through the roof. A standard 200g stick of butter now costs around 200 rubles, or around US$ 2. CNN photo from a Supermarket in Saint Petersburg. Inflation is high in Russia and people are worried that butter prices have gone through the roof. A standard 200g stick of butter now costs around 200 rubles, or around US$ 2. CNN photo from a Supermarket in Saint Petersburg. https://edition.cnn.com/2024/11/18/economy/russia-inflation-new-heights-intl-analysis/index.html

Russia is struggling to control a stubbornly high inflation. The Russian Central Bank blames the shortage of manpower, which in their view is producing ‘wage-push-inflation’, so they want unemployment to go up by stopping economic growth. But there are other ways to control inflation that would be more beneficial to common people in Russia.

Russia has performed much better than expected the last couple of years despite Western sanctions. Economic growth was 3.6% in 2023 and is expected to be close to 4% in 2024, capacity utilisation is unprecedented high, unemployment is at a historic low and there is a huge unsatisfied demand for more workers. As a result, real wages and household incomes have increased.

However, inflation has been stubbornly high and it looks as if it was accelerating in end 2024. The Central Bank is trying to bring inflation down by increasing the interest rate, set at 21% in end 2024. With an inflation of 8-9% the real interest rate is 12-13% which is making almost all investments unprofitable and threatening to seriously distort and damage the economy.

I am not an expert on the Russian economy, but it seems to me that there is something wrong with the Russian Government’s and Central Bank’s strategy to reduce inflation. The idea of increasing the interest rate is to make loans more expensive and in this way reduce lending both to consumers and business and thus slow economic growth. This has not been working up to now, even if there was in end 2024 signs of a slowing of the economy (as intended). The Russian Government is hoping for a ‘soft landing’ with growth falling to 2-2.5% in 2025 while the Central Bank projects 1.5%. But that may not happen.

To understand the inflation it is important to take into account that Russia is presently in a process of radical restructuring of its economy, reindustrialising and reorienting its foreign trade away from the EU to the East and the South. It is quite normal that countries that are in a process of profound restructuring of their economy are experiencing inflation during this process as relative prices are shifting and when that happens it tends to be upwards. It is also true that runaway inflation can seriously harm this transformation of the economy, so the Central Bank and the Government are rightly worried.

Russia is developing its transport corridors to the East and the South. The North-South Transport Corridor through Iran to India is still under development. It is presently working only by ship over the Caspian Sea or by rail on the eastern side of the Caspian (through Kazakhstan and Turkmenistan), while for the western route there is still a piece of rail-road lacking between Azerbaijan and Iran, the construction of which Russia will finance. Map: Wikipedia.

The restructuring requires huge investments in new production capacity and infrastructure, among these new transport routes, which is a serious challenge, not least in the middle of the war in Ukraine, where no end is in sight yet. One of the reasons the Central Bank’s high interest rate has a limited impact is that the Russian Government at the same time is supporting the restructuring of the economy providing preferential loans and subsidies to priority projects, either directly or by subsidising the interest on bank loans. Preferential loans are claimed to constitute 15% of the banks’ total portfolio, so they are substantial. These priority projects are linked to expansion of the production capacity (arms, civil aircraft construction, electronics, construction of commercial ships, machine tools, machinery for construction and agriculture, and so on), what they call ‘technological sovereignty’ (developing new products to substitute what is no longer available from NATO countries), and infrastructure (railways, roads, airports, hospitals and so on). So the Central Bank and the Government are pulling in opposite directions.

However, the Central Bank team sees it as its main goal to provide price stability, not full employment or economic growth. Their thinking is that the low unemployment rate is detrimental as it creates ‘wage-push-inflation’ because the companies transfer the increased wage-bill to their prices. So their only recipe for bringing down inflation is to bring economic growth down and unemployment up to stop wages from increasing. The team in Russia’s Central Bank has consistently underestimated the growth potential of the Russian economy with an active industrial policy. It seems to me that it has a too narrow understanding of the economy and the present sources of inflation.

In the accelerated restructuring of the economy there are no doubt bottlenecks in many sectors, and this creates an opportunity for companies to increase prices. In many cases monopolistic conditions are created. As an example, companies with full or partial public ownership and private companies considered strategically important, including banks, have to transfer their systems to Russian software. In Russia, the large majority of small and medium companies have traditionally used inexpensive enterprise management software from a Russian company called 1C, while the big companies have used the (expensive) German SAP. Now 1C has developed a product to substitute SAP, but there are complaints that the product is not up to the level of SAP and is too expensive. I don’t know if that is justified, but it is a possibility. Cases like this call for oversight and possibly regulation, not hiking of the interest rate.

As part of the drive for ‘technological sovereignty’, Russia's microchip industry is projected to grow significantly, boosted by massive government support. But it still has a long way to go. Image: Moscow Center of SPARC Technologies

There is clearly a different understanding of the economy and the causes of the present inflation in the Central Bank and the Ministry of Economy. The Ministry of Economy together with the public and private enterprise sector has been arguing that the endless hiking of the key rate is not an appropriate instrument for fighting inflation as it is distorting and simply killing the economy (which of course will bring inflation down, but at a high cost). They argue that in stead a supply side policy should be followed. Where supply is insufficient, measures should be taken to increase supply (loans and subsidies), and when necessary, imports should be facilitated to bring prices down. The key to address the lack of manpower is to increase productivity, among other by investing in industrial robots, an area where Russia is an international laggard. Where monopolistic practices are identified, prices should be regulated, and generally competition should be stimulated. It appears to me as a more reasonable approach.

Anyway, if the aim is to cool the economy, the Central Bank can use other instruments than the key rate to reduce lending to non-priority areas (as consumer credit or mortgages) and still keep credits flowing to priority projects for expanding the production capacity in sectors with unsatisfied demand, social housing and the like. The fact that most of the banking sector is publicly owned should make this easier, but that would require cooperation between the Central Bank and the Ministry of Finance, and that is anathema to many of the economists in the Central Bank, keen on maintaining their coveted independence.

The other alternative is that the Government can take direct measures to reduce demand. This can be done by reducing Government expenditure (for example postponing investment projects that are not an urgent priority) or increasing income taxes (hiking VAT and other indirect taxes is at this moment a bad idea as it would increase inflation). Income tax is very low in Russia at 13-15% (30% for those residing outside the country) so there is room for increasing it, for example by imposing a temporary tax on higher incomes.

A political struggle is apparently going on between the Ministry of Economy and the Central Bank on how to proceed to reduce inflation, a goal both are pursuing. It was expected that the Central Bank would increase the interest rate further to 23% in December 2024, but it finally desisted (possibly because a comment from President Putin that he hoped for a ‘balanced’ rate decision).

What happens in 2025 is anyone’s guess. My guess is that a compromise will be found, so inflation will go somewhat down, but economic growth will continue. But that is only a guess.

 

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I have been writing on the Russian economy since 2014. I am not an expert on Russia at all, but because of all the obvious nonsense that purported experts have been publishing in mainstream media, I have felt the need to read what better informed people are writing and look at the data myself. To read earlier articles on the Russian economy, click on the links below.

January 2025: Is Russia’s economy finally collapsing?

July 2023: Is the Russian economy really a mystery?

October 2022: Why does most of the world not participate in the sanctions against Russia?

August 2022: Can sanctioned countries survive?

October 2017: The dying bear.

September 2017: The imminent demise of Russia.

October 2015: Putin – the man we love to hate.

September 2014: Will sanctions hurt Russia?

 

 

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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