Analysis of the interaction between monetary and fiscal policies in Russia

Macroeconomic realities in Russia over the past four years have been exceptional in many ways. Economic growth rates have remained relatively high since the 2022 downturn. However, inflation has risen significantly, followed by high interest rates approved by the Bank of Russia. A situation has arisen where fiscal policy was stimulative, while the Central Bank has consistently taken measures to cool the economy. Meanwhile, high interest rates result in expensive budget deficit financing and lending to businesses, while inflation remains high despite the Central Bank's tight policy. Could this have been avoided? Was there a breakdown in coordination between the Russian Ministry of Finance and the Bank of Russia? Could the regulator have kept inflation under control?

The accelerating inflation in recent years has many causes, including the impact of sanctions, which have increased the cost of importing final goods and components and reduced foreign exchange earnings. Increased budget expenditures, which grew at an average annual rate of 16% from 2022 to 2024, also contributed significantly to price growth. While previously the budget spent more during periods of recession and limited expenditures when the economy returned to growth, in 2023–2024, despite record low unemployment and high rates of output growth (more than 4%), the growth of budget expenditures outpaced the growth of revenues, resulting in an increase in both the deficit and the share of public spending in GDP. This fiscal expansion created a strong stimulating effect on aggregate demand, leading the economy into a state of overheating, marked by high inflation and low unemployment. Russia's experience in recent years has shown that the Central Bank's ability to cool aggregate demand is significantly limited amid abovementioned reality.

We can conclude that the Bank of Russia had limited ability to prevent or significantly mitigate the inflation shock for two reasons. First, it was necessary starting the policy tightening cycle much earlier than July 2023. However, macroeconomic data available in H1 2023, including inflation dynamics data, evidenced a confusing story and did not clearly indicate any signs of a new wave of inflation. Since decisions on a key rate have a lag in influencing inflation, monetary authorities had virtually no opportunity to promptly and effectively dampen the demand. Second, the interest rate level required to stabilize price dynamics was so high that it could, with significant probability, trigger a large-scale liquidity crisis, threatening the loss of financial stability and sustainability of the banking sector, as well as cause a cascade of bankruptcies among enterprises in the real sector, disrupting production chains and risking a rapid slide into recession. Amid these realities, the Bank of Russia's management decided to implement a soft landing scenario by incurring a temporary acceleration in consumer inflation. Therefore, in this case, it would be incorrect to mention a breakdown in coordination between budgetary and monetary authorities. Structural resetting of the Russian economy was accompanied by rising prices and increased economic activity, and the role of the Central Bank of Russia was to curb this growth and prevent the development of critical imbalances.

The prevailing conditions of external sanctions pressure, which have caused problems related to aggregate supply and the need for budget support for the economy, have made it difficult for the Central Bank of Russia to maintain price stability, forcing it to raise interest rates to an extremely high level. As the economy approaches a balanced development path, fiscal and monetary policies will also normalize.