Fighting Inflation Needs to Be a Top Priority
- By Martin Gilman
- Feb. 11 2009 00:00
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It was announced on Thursday that Russia's inflation rate rose in January for the first time in five months as a result of increases in utility rates and higher costs of imports fueled by negative real interest rates and a rise in government spending.
The annual inflation rate rose to 13.4 percent, and consumer prices rose 2.4 percent from December. Food prices gained 15.9 percent in the year through January, while the cost of services, such as electricity and heat, rose 16.9 percent. Inflation has barely reflected the impact of ruble devaluation, so inflation will likely accelerate in February and March.
Russia's decoupling from the rest of the world has been sudden. Just six months ago, the inflationary surge was a global preoccupation for everyone, including the United States, the European Union, China and nearly all emerging economies. At that point, what was happening in Russia could have been interpreted as part of the global price surge.
Now Russia stands alone among the G20. (Although Ukraine's price performance is even worse, it is not a member of the G20.) The Economic Development Ministry estimates that inflation could reach 13 percent in 2009. The latest International Monetary Fund projections for 2009 show no other G20 country with expected inflation in the double digits. Even normally inflation-prone countries like Argentina, Indonesia or Turkey are expected to see price levels rising by no more than 6.8 percent, 7.3 percent and 7.9 percent, respectively. The IMF projects Russian inflation at 12.6 percent.
The irony is that Russia has decoupled at a time when many advanced countries are seriously worried about the specter of deflation.
Russia's monetary policy has been too loose for far too long as witnessed by negative real interest rates (that is, adjusted for inflation). This may have been good for banks but is fatal for the economy over time. Continuing high rates of inflation represent a real threat to not only a quick exit out of the immediate economic crisis but could seriously jeopardize a resumption of medium-term economic growth and development.
Many argue that inflation should be relatively low on the priority list of the Russian government at this juncture. After all, output, unemployment, the budget, balance of payments and the ruble exchange rate should arguably be the policy priorities. With Russia mired in a globally induced recession, maybe now is not the time to worry about the level and trajectory of price increases?
This would be wrong. Bringing inflation quickly under control is critical to the realization of the other economic goals. We have learned with surprising abruptness in recent months how intimately Russia is linked to the global economy, and we must understand that the country's inflation inertia cannot be decoupled from a solution to its other economic challenges.
In the current challenging economic environment, there are some factors over which Russia has no control. Like everyone else, Russia will just have to accept what happens to oil prices and the fate of the U.S. dollar. Both values could remain as volatile in future as they have been last year.
But inflation is largely within the government's control. Monetary policy should be tightened and interest rates need to be raised dramatically to positive real rates. Fiscal policy should also play a supporting role in trimming the excess spending out of the revised 2009 budget.
Perhaps such advice seems counterintuitive at a time when everyone else in the world is throwing money at their economic problems. The contrast is more nuanced. Substantial public resources are being directed at macroeconomic stabilization and support for the banking sector. Even with some trimming, the shift from Russia's budget surplus in mid-2008 (4 percent of gross domestic product) to a budget deficit in mid-2009 (estimated to be 6 percent of GDP) is likely to be more than double the similar shift that will take place in the United States.
The belated implementation of a much tighter approach to liquidity will not only dampen price rises but will also help support the ruble. Having had the political courage to adjust the rate in line with the drop in oil prices despite the nervousness of the population, there is a serious risk that the new ruble floor will not hold for long if the real rate continues to appreciate because of rising prices. No amount of reserves will be able to resist market pressures if the country loses its recently rediscovered competitiveness because of inflation.
Of course the real appreciation of the rate is not alone in explaining Russia's current economic tribulations, but inflation has caused enormous damage. Besides the exchange rate, negative real interest rates distorted investment decisions, making the non-oil economy much less resilient in weathering a downturn. Inflation has undermined the competitiveness of Russia's manufacturing industry at a time when the oil and commodity sectors are in the grip of a severe price slump.
Lower inflation will eventually allow for lower nominal rates of interest, lowering the cost of credit to Russian households and companies. With less of a differential compared to rates in other countries, the incentive for large destabilizing capital flows should also subside. And with positive real interest rates, investment can be more efficiently allocated by the private sector. This will be a crucial factor for the realization of a diversified and growing non-oil economy.
In recent days, we have seen some tentative steps taken by the Central Bank to fight inflation, but much more needs to be done. If the path ahead is so obvious, why the reluctance? The banks are the problem. Obviously, their borrowers have not benefited from the low real rates charged by the Central Bank to the banks. Assuming that competition can work, higher policy rates need not affect the economy adversely. But bank margins would be squeezed and they would have much less scope for profitably betting against the ruble. Banks may even need to consider doing serious credit analysis and lending to the economy. The inevitable cost will be defaults and the need to recapitalize what remains of the country's banking system after the widely expected consolidation.
In the end, hopefully we will see a policy-induced inflation surprise this year. Once the higher prices of food imports, owing to the rapid depreciation of the ruble, work through the system in coming weeks, we could see a big, pleasant drop in inflation. We could ultimately see a strengthening of the ruble in a higher interest rate environment. It is really the choice of the Central Bank and Finance Ministry. This is the real test of their courage to do what is right for the country despite the short-term costs and political pressures.
Martin Gilman, a former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics.