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ECONOMY UPDATE: Inflation falls to 2.4%; but manufacturing stalls in October

Central Bank’s tough monetary policy accelerates inflation fall, but continues to put heavy pressure on living standards on the eve of the March election

The Central Bank’s constant expectations of an inflation take-off in Russia continue to be confounded with confirmation from Rosstat – Russia’s state statistical agency – that Russia had zero inflation again last week, bringing the annual inflation rate down to 2.4%.

This comes just days after Central Bank Chair Nabiullina guessed wrongly that the annual inflation rate was 2.6%.

With November approaching its end, there will have to be a sharp rise in inflation in December if the overall inflation rate for 2017 is going to be significantly above 2.5%.  Suffice to say that the official forecast now is that it will be between 2.5% and 2.8%, whereas at the beginning of the year the expectation was that it would be 4%.

This is a mighty inflation overshoot, and it has left Nabiullina floundering for a reason both to explain it and to justify her continuing with her ‘moderately tight monetary policy’, which has left Russia with the highest real interest rates – now 5.6% – in the developed world.

Yesterday she was reduced to conjuring up the ‘Olivier salad index’ by saying that popular expectations of the future price of Russia’s beloved Olivier salad – what the rest of the world would call a ‘Russian salad’ – remain very high.

What Nabiullina was of course referring to are inflation expectations – ie. what people expect future inflation to be, as opposed to what it actually will be – which in Russia continue to be much higher than the actual inflation rate justifies.

Given the recent history of double digit and sometimes even triple digit inflation every year in Russia between 1991 and 2011 save 2009, and of the double digit inflation spike of 2015, it could not be otherwise.

Inflation expectations are something the Central Bank obviously needs to take into account in case they lead to a surge in demand for higher wages.

However of that there is no sign, and given how fast inflation is falling talking about the price of Olivier salad seems a strange way to justify keeping real interest rates as high as they currently are.

It bears remembering that the interest rate ordinary Russians pay when they take out loans is much higher than the 8.25% the Central Bank charges banks, whilst the interest ordinary Russians get paid on money they have on deposit with the banks is of course much less.

The result is a continuing squeeze on living standards, which according to Rosstat fell again in October despite the inflation fall, which is in turn leading to a fall in demand.

This almost certainly is what lies behind the fact that for the first time since February Rosstat reported manufacturing at a standstill in October. This came as a surprise after months of steady growth, but is consistent with signs of a falling off of growth in recent weeks.

A recent industrial managers’ survey shows that the single most important factor cited by industrial managers as holding back growth is a lack of demand.

I am not someone who normally takes too much account of the opinions of people like industrial managers when they talk about the overall economic situation.  In my experience such people tend to be either excessively over-optimistic or wildly over-pessimistic, and their economic expectations rarely turn out to be right.

in this case however what the industrial managers are saying is so wholly in line with the macroeconomic conditions the Central Bank has created that it is simply an exercise in denial to discount it.

A consistent feature of the Central Bank’s decision making since the December 2014 rouble crash is that it repeatedly scares itself – and gives as reasons for keeping interest rates higher than they should be – with disaster scenarios which never happen.

Thus in early 2016 it predicted that the sharp fall in oil prices at the start of the year would lead to a second inflation spike that year with inflation hitting double digits.  Instead inflation actually fell throughout the year.

At the start of this year it predicted that oil prices would fall to $40 a barrel by year end, putting renewed pressure on the rouble, and therefore causing inflation to rise.

Instead Brent crude is today trading at $63 a barrel, the rouble has risen, and instead of rising the inflation rate has fallen below the Central Bank’s target.

Now the Central Bank is scaring itself with predictions that the harvest next year will be smaller than it was this year, and that oil prices will fall again next year.

Perhaps both things will happen, and if they do the Central Bank will have to deal with them in a proper and timely way.

However I for one am completely unable to see how the Central Bank or anyone else can at this point in the current year predict with any confidence what size Russia’s harvest is going to be next year, whilst the historical record shows that anyone who thinks they can predict what oil prices will be a year ahead with any confidence is a fool.

Every so often one comes across suggestions that this year’s inflation overshoot is somehow a good thing, since it brings Russia’s inflation rate closer in line with the 2% annual inflation rate which is now typical of the developed economies.

Alexey Kudrin, Russia’s former Finance Minister, is on record as saying that Russia should aim for an annual inflation rate of 2% to 2.5%.

Bringing the annual inflation rate down to an annual rate of 2% is indeed a worthy aim, but why must it happen now?

I say this because I heard Nabiullina say in my presence at a bankers’ conference at St. Petersburg’s SPIEF conference in May 2014 that the Central Bank’s calculations were that for Russia at this stage in its development a 4% annual inflation rate is optimal, allowing possibilities for saving and long-term investment without stifling growth.

Why not stick to that, let inflation remain at 4% for a few years so that growth can pick up, and then tighten up again to bring inflation down to 2% once economic conditions have matured and become more stable?

To be clear, I am not saying and have never said that Russia should drift back into the territory of negative real interest rates (ie. interest rates below the rate of inflation) in which it found itself for most of the period following the Soviet collapse in 1991.

But Nabiullina herself has now said that a proper level for the Central Bank’s key rate in the medium term is 6% to 7%, which assuming an inflation rate of 4% speaks of real interest rates of 2% to 3%, not the more than 5% which she is inflicting on the economy now.

Nabiullina however continues to have Putin’s support, and though there are once more murmurs against her policy coming from within the government I expect her ultra hardline views to continue to prevail, at least for the time being.

What that means is that despite the recovery – which to be clear will continue despite the manufacturing setback in October – Russia will enter the election season in March with the strong likelihood that living standards will still be falling, more than a year after the recession ended.

I cannot imagine any other government or Central Bank anywhere else in the world behaving in this way on the eve of an election, and not surprisingly there are now the first signs in some opinion polls that levels of public dissatisfaction are starting to rise.

Given Russia’s overriding need for political stability that makes it all the more important that Putin runs again in March, since he remains the one person who as the same opinion polls show still has the Russian people’s overwhelming confidence.

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