The Inflation Trajectory Will Be Determined by the Level of Confidence of Economic Agents

Last week, the Bank of Russia issued a revised forecast of Russia’s economic development in 2016-2018, which takes into account the risks that emerged in Q4 2015.

First of all, the new risks are associated with the drop in the monthly average crude oil prices from $ 49 per barrel and $ 46 per barrel in October and November, respectively, to $ 41.6 per barrel in early December. Moreover, on 12 December its minimum price declined to $ 38.1 per barrel. Secondly, Russia will have to face the risks associated with the recent decision of the US Federal Reserve to raise interest rates and the resulting strengthening of the US dollar on the global financial market. Thirdly, Russia-Turkey relations have experienced a sharp deterioration, and in all likelihood Russia will ban the import of some Turkish goods starting 1 January 2016. These developments will certainly result in an increase in inflationary pressures. It is noteworthy in this respect that, according to the Bank of Russia, imports from Turkey in Q2 2015 constituted 9.5% of Russia’s total imports of goods and services.

Within the framework of the baseline scenario of the Bank of Russia’s forecast, as well as in its Guidelines for the Single State Monetary Policy in 2016 and for 2017 and 2018, it is expected that the price of Brent crude oil will gradually increase to $ 50 per barrel and then remain at this level throughout the rest of the forecast period. If Russia then pursues a relatively tough monetary policy that will reduce the annual pace of price growth to the target of 4% in 2017 (%, December of year / December of the previous year), the annual pace of GDP decline in 2015 will go down to 0.5%-1%, and as early as 2017, GDP will resume growth.

However we believe that the most interesting revised scenario of the Bank of Russia’s forecast – not just from an analytical point of view, but from a practical point of view as well - is the (highly realistic) stress scenario. This scenario is geared to the specific features of the Bank of Russia’s monetary policy and to the risks associated with its implementation. The stress scenario envisages, firstly, that oil prices will decline to $ 35 per barrel in 2016 and then will float at a low level over the medium term; and secondly, that the worsening of the conditions for successful attraction of external funding will last longer than under the baseline scenario.

It can be expected that under these conditions Russia’s economy will face a rise in exchange rate pressures and, consequently, a notable increase in inflation pressures. However, in spite of the receding pass-through effect of the ruble's exchange rate fluctuations into commodity prices, as well as the toughening of Russia’s monetary policy expected by the Bank of Russia, the actual growth rates of consumer prices will rise above their target trajectory. In 2016, consumer prices will grow by approximately 7% (%, December of year / December of the previous year). Nevertheless, bearing in mind that under these conditions Russia’s GDP will decline by 2 to 3%, the Bank of Russia is planning to further loosen Russia’s monetary policy by reducing the key interest rate, although the pace of its reduction will be slower than that envisaged under the baseline scenario.

The Bank of Russia will agree to toughen its monetary policy in response to the actual growth rates of consumer prices having exceed the target only if the duration of the inflationary risks provoked by a considerable growth in the prices of, for example, agricultural goods, unrelated to the regulator’s policies or caused by a change in Russia’s budgetary and/or tariff policy, will exceed the time horizon of 1-1.5 year time horizon, traditional for such cases.

On the whole, we believe that the effectiveness of the Bank of Russia’s monetary policy will depend on whether or not it will be able to control the inflationary expectations of economic agents and, consequently, the level of their confidence. Under conditions of the rapid adaptation of Russia’s external environment, the inflation trajectory will be determined by the level of confidence of economic agents in the ability of monetary regulatory bodies to prevent financial instability and to achieve a decrease in the rate of inflation.

Anna Kiyutsevskaya - Researcher