The Fed Can Help Russia Lower Its Inflation

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Everyone agrees that inflation, which already reached an annual rate of 14.3 percent last month, is a problem. President Dmitry Medvedev said as much in recent speeches, and Prime Minister Vladimir Putin underscored the need to tackle inflation in his job interview with the State Duma on Thursday. As if to underscore the urgency, May 1 demonstrations against price increases revealed that tolerance of inflation might be wearing thin.

So what can the new government do to tame a problem that seems to be a global scourge?

The challenge is not new. Shortly after Prime Minister Viktor Zubkov's government was formed in September, the fight against inflation was elevated to a top priority. Finance Minister Alexei Kudrin was given the task of proposing concrete measures to solve the problem. But other than the postponement of some needed administrative price increases and a few ineffectual controls on the prices of food items, which were lifted on May 1, the steps to fight inflation have been insufficient and the results have been meager.

Can Putin's new government do any better?

It's important to understand that the acceleration of inflation in Russia since the fall is rooted in both domestic and external factors. The Central Bank was quick to blame global supply problems on rising food prices. But international inflation of food prices appears to be slowing, while they are still rising in Russia. And nonfood inflation continued to accelerate to an annualized rate of 8.1 percent by April.

This adds weight to the argument that domestic factors are driving inflation in Russia. A 45 percent annualized increase in budgetary spending in the first quarter 2008 was probably the major reason for the spike in inflation, in conjunction with a rise in broad money of a similar magnitude.

But it is clear that the problem with inflation is deeper and more widespread. From China to Saudi Arabia, the common cause seems to be the abundance of liquidity emanating primarily from Washington, as the Federal Reserve opens the spigot to cushion the economy-wide impact of the price collapse in the key U.S. housing market. With the dollar still fulfilling the role of the key reserve currency, it is hard for other countries to escape the fallout, and Russia is certainly no exception. In these circumstances, what can be done? The options are limited and none of them comes without serious side effects.

• Float the exchange rate. The International Monetary Fund has advised Russia to do this for a long time. The IMF argues correctly that the Federal Reserve essentially sets Russia's monetary policy as long as its currency is pegged to a basket that includes the dollar as the largest component. Similarly, at the beginning of this month, when the April price numbers were published, some investment banks concluded that the Central Bank will have to let the ruble appreciate to contain the upward trend in inflation.

The problem with such advice is that it is likely to be largely ignored in the short-term because there are significant costs involved in appreciating the ruble. In addition to an unwelcome loss in competitiveness just as the government wants to diversify the economy away from energy, the country also faces a medium-term external account deficit with the sharp increase in imports.

More critical, the policy could actually backfire as it did in early 2007, when the Central Bank suggested a stronger ruble and broad money exploded from resulting capital flows -- thus, jump-starting the current inflation problems. Global capital has created bubble-like conditions for some commodities, and it could do the same for the ruble if the Central Bank is not careful.

• Tighten monetary policy. In principle, tighter monetary conditions should choke off inflation. The problem is that market-related instruments like higher interest rates -- while desirable for the long-term health of the banking sector -- could again open the floodgate to capital inflows. Any significant tightening would thus be neutralized by the market. Nonmarket instruments, like reserve requirements, effectively ration credit and could cause a domestic credit squeeze in the middle of the current international financial crisis. This would force some medium-size banks into bankruptcy because of liquidity problems and raise the costs of banking in general. In the end, this could suppress future development.

• Tighten fiscal policy. Kudrin's conservative budgets have been the critical counterweight to the Central Bank's loose monetary stance in recent years. If anything, as the IMF suggests, this admirable policy mix should now be reversed. Economic Development Minister Elvira Nabiullina is absolutely right when she says more needs to be spent to help Russia adapt to 21st-century standards of living. Especially with oil prices over $120 per barrel, it's hard to imagine that spending can be further restrained, no matter how conservative Kudrin would like to be. As it is, with the new prime minister suggesting tax cuts and spending increases, Kudrin may even have difficulties in keeping the budget surplus from shrinking below 4.3 percent of gross domestic product this year from 5.4 percent in 2007.

• Direct controls. Administrative controls over prices and margins in every country that has tried them have been proven ineffective because they create serious distortions over time. Since they don't address the underlying demand pressures, controls simply delay these problems or bottle them up. And, in a country like Russia, where good and honest administrators are still all too rare, the last thing needed is a new bureaucracy to administer controls.

In the face of this sustained inflationary surge, the ideal policy change would not come from Moscow at all. It would come from Washington. A tightening of U.S. monetary policy and a strengthening of the dollar would contribute to a serious disinflation process in Russia. In that case, as the key reserve-currency country, the United States would once again be exporting stability throughout the global economy and Russia would be a direct beneficiary.

For once, at least in the area of economic policy, the United States and Russia must be praying for the same thing -- that the U.S. economy bottoms out in the third quarter and starts a strong recovery in the fourth quarter, allowing the Federal Reserve to tighten monetary conditions.It seems that many Wall Street investors are already counting on such a scenario. We should hope that they are right. Such a welcome withdrawal of liquidity from the system could come just in time to relieve the inevitable pressure on the social safety valve in Russia.

If it doesn't, and if the United States stays in a prolonged downturn with the Federal Reserve continuing to accommodate with a loose monetary stance, then the Kremlin will be faced with some very difficult policy choices as Russians begin to run out of patience.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.