On Friday, the Central Bank of Russia cut its main lending interest rate from 15 percent to 14 percent. What does it mean in the context of the ongoing crisis in Russia? Could this decision affect the gold market?
Russia’s central bank has slashed its interest rates the second time in two months. In January, it surprisingly cut rates from 17 percent to 15 percent, just a few weeks after the big hike from 10.5 percent in December which hike was supposed to prevent capital outflows and defend the ruble. The last action clearly indicates that the central bank considers the rapidly declining economy a more serious threat for the economy than high inflation. According to the official announcement:
"On 13 March 2015, the Bank of Russia Board of Directors decided to reduce the key rate from 15.00 to 14.00 percent per annum taking into account that the balance of risks is still shifted towards a more significant cooling of the economy."
Definitely, the Central Bank of Russia faces a very unpleasant dilemma, as the Russian economy is experiencing ‘slumpflation’, i.e., a simultaneous decline in GDP and a double-digit inflation rate. Just as a remainder, Russia’s GDP will fall by 3.5 - 4.0 percent this year, according to the Central Bank of Russia’s estimates, while the annual CPI growth rate stands at 16.7 percent (as of March 10).
It is true that lower interest rates may stimulate the economy a bit (but they are unlikely to help the economy avoid a deep recession); however cutting them during a period of such high inflation seems to be a bit surprising. The Russian central bank argues that a considerable rise in annual inflation observed in December 2014 – February 2015 (see the chart below) was caused mainly by the food import ban and the ruble’s depreciation, and was a temporary phenomenon. According to the central bank, it should focus not on the current, but the future inflation rate, which will be gradually declining due to weak economic activity.
Figure 1: Russia’s CPI inflation rate between 2012 and 2015.
Undoubtedly, the coming recession may bring about lower inflation, however investors should remember two things. First, the changes in exchange rate do not cause price inflation, but mainly reflect the anticipation of future inflation. Second, inflation is mainly a monetary phenomenon. It means that we can see high inflation despite weak economic activity, just as in the 70’s in the U.S. A lot depends on the pace of monetary pumping. So far this year, the annual money supply (M2) growth rate has decreased considerably as compared with the beginning of 2014.
However, inflation may not be temporary if Russians lose confidence in the ruble. The last cuts create the impression that the Central Bank of Russia is under pressure from business and Kremlin circles to ease up, which weakens its credibility as the guardian of price stability. Shortly before the central bank’s action, VTB, the second-largest bank in Russia, reported zero profit for 2014 and said it would suffer significant losses without the interest rates being cut.
The central bank’s credibility may decline even more if it decides to monetize public debt (just to remind, on February 20, Moody’s downgraded Russia’s sovereign rating to junk status, the second credit rating agency to do so) or finance the bailouts of the banks and companies.
To sum up, the ruble has stabilized since a panicky collapse late last year; however this may only be the calm before the storm. The Central Bank of Russia clearly signals that it intends to take care more about the banking system than price inflation, which means that the ruble may be falling again in case of any significant deterioration of the situation and loss of confidence. In such a scenario, the demand for gold as safe-haven should increase.
Thank you.
Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor
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