Russia Faces Stagflation: The Central Bank’s Tough Choices at 21% Interest Rates

This the end of the interest rate increase cushion. Every point from here will bring more pain than relief.

Why does the Russian Central Bank keep increasing interest rates?

Primarily, it’s to control inflation.

How did it start?

The Russian central bank acted swiftly after Western nations imposed sanctions on Russia following its invasion of Ukraine.

They had a plan, and it proved highly effective.

Just weeks after the invasion, the Russian central bank raised the interest rate to 20%, which helped prevent an outflow of money from Russian banks and stabilized the Ruble, avoiding a collapse. With billions saved in the national wealth fund, the sharp rate increase and government savings jointly protected the Russian economy from the severe impacts of Western sanctions.

But that was only the first phase, which the Russian central bank managed very well. Between March and September 2022, the central bank gradually lowered the interest rate from 20% to 7.5%, just 1.3 points above the pre-war level, and left it untouched for almost a year. However, inflation began to surge as Putin continued drawing tens of thousands from the workforce, and, to offset the resulting loss in productivity, he pumped state funds into the economy.

This fueled inflation, driving it up month after month. In response, the Russian central bank resumed increasing interest rates.

What is the connection between interest rates and inflation?

I believe there are three key factors at play in Russia’s situation: prices, currency, and wages.

• Stop Price Increase: Higher interest rates make borrowing more expensive, whether it’s for mortgages, car loans, or business expansion. This leads to reduced spending by consumers and businesses because people tend to borrow less and save more. Lower spending reduces the demand for goods and services, which can help prevent prices from continuing to increase.

• Strengthen Ruble: A stronger currency makes imports cheaper, which can help reduce the price of goods and services imported from abroad, contributing to lower inflation.

• Reduce the Pace of Wage Increases: When inflation is high, workers demand higher wages to keep up with rising costs. If wages increase, businesses often pass those costs onto consumers in the form of higher prices. Higher interest rates aim to limit this feedback loop, known as the “wage-price spiral,” by slowing demand and preventing wages from accelerating too quickly relative to productivity.

Elvira Nabiullina, Russian Central Bank Chief, is incredibly talented and proficient in her work. She used every tool at her disposal to prevent the Russian economy from collapsing, and for the most part, she has succeeded. However, with rates now at 21%, the ability to use interest rates to control inflation without causing immense hurt to other parts of the economy is effectively exhausted. She has no more room to maneuver.

As of July 2024, the Russian National Wealth Fund was at a historic low of about $55 billion.

Image Credit: Tochnyi

Thanks to the rising value of gold since January 2024, Russia has been carefully selling gold to conceal the fact that it continues to draw from the National Wealth Fund. This is why the fund’s value has remained stable since January 2024.

Gold Price. Image Credit: Gold. org

But is there a reason why Russian authorities are avoiding large withdrawals from the National Wealth Fund?

The answer came from Russian Central Bank Chief Elvira Nabiullina herself. At the end of June, when she raised the interest rate to 18%, she issued a direct warning to the Kremlin on July 26:

All resources in Russian economy are exhausted. Inflation is rising, interest rates cannot be significantly increased. Extreme lack of the workforce. Adding money from reserves to market will just increase inflation without bringing new growth. Russia is likely facing stagnation or deep recession.

She is doing everything possible to keep inflation in check; it remains her top priority, and she’s on point with it. If inflation spirals out of control, the situation could deteriorate rapidly, so she continues to buy time for Putin. The problem, however, is that Putin’s policies show no signs of slowing down.

The consequence of repeatedly deferring the economic crisis is a looming risk of a severe crash. With interest rates at record highs, the CEO of Rostec recently warned the Kremlin that stagflation is not far off and that the entire Russian industrial sector could soon collapse.

“If we sign contracts for products whose production cycle is more than a year, then, naturally, the maximum advance payment we receive is 30–40%. The remaining funds for producing these products must be borrowed. And with such an interest rate, all the profit that we anticipate is eaten up by the interest that we are forced to pay to the bank.

If we continue to work like this, then most of our enterprises will go bankrupt”.

After warning the Kremlin about the impact of high interest rates, he shifted his focus to the threat of stagflation.

“A conservative financial policy can lead to stagflation. This term may not be familiar to everyone, it is not used very often. Stagflation is when both production and consumption fall simultaneously. But at the same time, inflation grows at a high rate,” he said, specifying that the result of such a policy is an increase in prices and unemployment. “Unfortunately, we can come to this. This, in general, does not happen very often in the economy, but there are such examples.”

He’s right. And so was I.

At the end of June, I wrote that there is a bloodless to way to end the war:

When interest rates are at 18%, you can’t do anything. Niether you nor the corporations. Every body will be in a hole without a path to climb out. The Russian economy is on the edge. All it needs is a little nudge to topple over.

I even offered a clear path way to put the Russian economy under pressure: “If the United States and Europe reduce Russia’s daily oil revenue by 5% to 10%, the impact on the Russian economy will be huge. They should keep siphoning off a few percentage points every month for the next several months”.

Just imagine — if we had intensified sanctions and increased pressure over the past three months, the Kremlin would have faced immense challenges in funding the war. We can still make this happen. We need to do this. Pressuring the Russian economy, already teetering on the edge, is the most effective way to end the war. It was. It still is. And it will continue to be.

I believe the Russian Central Bank Chief will continue to raise interest rates, even at the expense of Russian industry. However, the ability to protect all aspects of the Russian economy is now exhausted. She needs to make a choice: either prioritize inflation or support industry. That’s what I mean when I say the cushion for interest rate increases is gone. This doesn’t mean she won’t raise rates further; it just means that doing so will cause significant harm.

We have entered the collapse territory.