The Key Interest Rate’s Reduction by 1 pp. To Have Little Influence on Economic Activity

At the Bank of Russia Board of Directors' meeting on 13 March, it was decided that the key interest rate should be reduced by 1 pp. – from 15% to 14%.

As stated in the commentary to that decision, released by Russia's monetary authorities, the reason for the softening monetary policy had been the shift in the balance of risks towards 'a more significant cooling of the economy'. In other words, the regulator's official viewpoint is that the key interest rate has been reduced in order to boost economic growth or, more correctly, play down the recession effects. In this connection it should be noted that the drop in the interest rate by 1 pp. will have no significant influence on economic activity.

According to the RF Central Bank's own forecast, the year-end results of 2015 will demonstrate an economic decline of 3.5–4.0%, so a softer monetary policy will still make it impossible to avoid a pronounced recession. Therefore, in our opinion, the RF Central Bank's decision should be interpreted as a manifestation of its desire to maintain the current status quo. This means, on the one hand, that the regulator has chosen to abstain from an aggressive monetary expansion aimed at sustaining economic activity (while making every effort to make it known that no radical monetary policy softening scenario is being considered), while on the other, it implements no decisive tough measures designed to curb the ongoing inflation processes, for fear of a banking sector crisis and economic collapse.
Thus, the monetary authorities, by way of taking such a decision, are sending a clear signal that neither any considerable monetary easing, nor radical toughening of monetary policy should be expected. The decline of the key interest rate by 1 pp. can neither boost economic growth not trigger any inflation surge. This is a compromise solution, its main goal being to demonstrate that the policy pursued by the regulator is not going to change, and that the key interest rate will be gradually further reduced, albeit at a moderate rate depending on the actual progress of inflation expectations.

In our opinion, this monetary policy course implies balancing between the creation of monetary incentives to growth and the goal of bringing the inflation rate down to its targeted level. Any attempt to avoid a recession by means of monetary easing would have been a mistake, because its highly probable outcome would have been many years of stagflation. At the same time, in order to suppress price growth (which can largely be viewed as an 'echo' of the ruble's depreciation in the second half year of 2014), it will be necessary to revalue the national currency – an unrealistic goal without a radical monetary squeeze; this, in its turn, will not only be a strong blow to the already rather feeble economic activity, but also pose a threat to the financial sector's stability. The Bank of Russia is striving for a 'golden mean' between these two opposites, which appears to be a perfectly reasonable course. We believe that the top priority, for monetary authorities, should be to exercise strong control over inflation expectations, as well as to ensure the banking sector's sustainability in a situation when banks are beginning to experience loan repayment problems against the backdrop of economic decline.
As for the recent reduction in the key interest rate, it seems to be a premature measure, especially given the fact that, according to the regulator's own estimations, the inflation rate peak is yet to be anticipated, while the worsening foreign trade prospects may cause yet another decline of the ruble's foreign exchange rate and thus speed up the inflation rate due to the foreign exchange pass-through effect.

Yevgeny Goriunov – Researcher, Monetary Policy Department