September 6, 2019

Russian Macro – Falling Inflation to Pull Key Rate Down

BY Alexander Kudrin, Evgeny Gavrilenkov

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( 9 mins)

Rosstat reported that the YTD inflation reached 2.4% as of September 2, which is already lower than the cumulative inflation over the same period in 2018. In August a 0.2% m-o-m deflation was recorded implying that the cumulative inflation remained at zero in the summer months. Given that last year the m-o-m inflation accelerated in 4Q18, while this year inflationary pressure is not high, inflation may fall to around 3.4-3.5% by the year end and no later than in November 2019 it will have fallen below the CBR’s 4% target.

Decelerating inflation amid reduced inflationary pressures will allow the CBR to cut the key rate by more than 50 bps. However, given the CBR’s track record it looks quite unlikely that the regulator would be decisive enough to exceed this limit.

The ruble at 66-67 per dollar or weaker may once again encourage additional foreign capital inflows, causing unnecessary ruble appreciation, bringing about extra volatility and increasing risks of higher inflation. Therefore, cutting the key rate in the current environment not just seems supportive for economic growth alone, but should also be viewed as a measure aimed at keeping inflation less volatile, as it is expected to fall below the CBR target very soon.

  •  The CBR’s expected 50 bps rate cut by the year end can only preserve the status quo between domestic and global rates as the Fed is likely to orchestrate the same 50 bps cut in the coming months.
  •  Russia’s too high key rate was somehow offset by quantitative measures, such as Minfin’s daily ruble interventions to buy FX in line with the fiscal rule. These ruble interventions reached R2.5 trln YTD.
  •  This caused the money market rates, such as RUONIA, to stay below the key rate, so that the situation on the Russian money markets has remained distorted. When RUONIA retained low volatility and stayed consistently below the key rate for some period it was a signal for the CBR to cut the key rate. Hence the primary role of Minfin.
  •  The concept of the “neutral” key rate level which the CBR often refers to is not very straightforward in such an environment distorted by quantitative measures. A more reasonable “neutral” or an equilibrium level of the key policy rate can be found only after either the key rate is brought below the interbank money market rate, or if Minfin’s FX purchases are significantly reduced so that the money market rate rises and exceeds the key rate, but the latter option is not on the table.

Rosstat reported that the YTD inflation reached 2.4% as of September 2, which is already lower than the cumulative inflation over the same period in 2018. This estimate is based on the weekly inflation statistics, which is preliminary and is calculated for a narrower basket of goods and services compared to monthly inflation statistics, so that in some months the cumulative weekly inflation may not necessarily be equal to the official monthly inflation data. It is clear that the cumulative inflation remained at zero in the summer months. Given that last year the m-o-m inflation accelerated in 4Q18 to 0.4% in October, 0.5% in November and 0.8% in December, while this year inflationary pressure is not high and is not going to increase as much as in 4Q18, it cannot be ruled out that inflation may fall to around 3.4-3.5% by the year end. Last year, inflation reached 4.3%, while no later than in November 2019 it will have fallen below the CBR’s 4% target.

On the back of cheaper oil, which recently fell from over $70/bbl to around $60/bbl, the USD/RUB exchange rate settled in a rather comfortable zone, i. e. between 65 and 70. About a year ago GKEM Analytica identified this range as a rather stable equilibrium zone for the ruble, i. e. where the ruble is set to return in case of some deterioration of the external environment, be it a lower oil price or expectations of new sanctions. This range was calculated not only on the basis of such midterm factors as the oil price and the current account balance, but also on longer-term trends, such as the accumulated difference between the inflation rates in Russia and the US (the issuer of a benchmark currency) and the accumulated difference between Russia’s real GDP growth and that of the rest of the world. Therefore, any significant depreciation of the ruble looks highly unlikely in the coming months which will help to keep inflation relatively low.

Decelerating inflation amid reduced inflationary pressure will allow the CBR to cut the key rate by more than 50 bps. However, given the CBR’s track record it looks quite unlikely that the regulator would be decisive enough to exceed this limit. As a result, the gap between the key rate and inflation will not change much compared to where it stays now and will even slightly widen (as seen on the chart below). This gap will stay around 325 bps by the year end, which is quite high by the international standards, especially these days as many countries have policy rates that are negative in real terms. Another 25 bps cut would keep the status quo, i. e. preserve the gap between Russia’s y-o-y inflation and the key rate at the level seen in February – March 2019.

Russian Macro - Falling Inflation to Pull Key Rate Down 1

The CBR is expected to remain cautious as the m-o-m inflation is expected to rise in November December due to the usual seasonality, albeit not as much as it did in 2018. This acceleration, however, will move up the 6M moving average inflation (which is now below 2%) in December so that the y-o-y inflation and its 6M moving average measure will converge with prospects of an even greater convergence in 2020 amid expected lower volatility of the m-o-m inflation. Next year inflation is likely to get closer to 3%.

As GKEM Analytica pointed in its earlier reports, the too high key rate was somehow offset by quantitative measures, such as Minfin’s daily ruble interventions to buy FX in line with the fiscal rule. These ruble interventions reached R2.5 trln YTD and the country’s international reserves increased by around $60bln (this number is not immune to valuation effects, such as the gold price growth and cross-currency exchange rates fluctuations). It looks as though Minfin’s spending on FX purchases has already exceeded the fiscal surplus accumulated in 8M19 as the latter reached R2.0 trln in 7M18 and it is highly unlikely that that the federal budget surplus could have reached R0.5trln in August alone. Historically, tax collection is relatively low in August (compared to July). In July 2019 this surplus exceeded R0.3 trln. In the remaining four months of the year Minfin is likely to inject additional R1.2-1.3 trln via FX purchases so that such cumulative interventions are expected to exceed the federal budget surplus even more. Indeed, Minfin has plenty of spare cash left from 2018.

As a result, the money market rates, such as RUONIA, remained below the key rate, as the chart below shows. This chart also illustrates that when RUONIA retained low volatility and stayed consistently below the key rate for some period (excluding the end-month effects when money market rates temporarily go up ahead of tax payments) it was a signal for the CBR to cut the key rate. Hence the primary role of Minfin’s interventions which affected the money market rate, while the latter was telling the CBR what needs to be done to the policy rate.

Russian Macro - Falling Inflation to Pull Key Rate Down 2

The key policy rate, of course, influenced the benchmark OFZ yields and lending rates in other segments of money markets, such as consumer and corporate lending. However, the situation on the Russian money markets has remained distorted as the interbank market rate has consistently stayed below the key rate due to Minfin’s massive FX purchases. Therefore, the concept of the “neutral” key rate level which the CBR often refers to is not very straightforward in such an environment distorted by quantitative measures. As in this case the key rate seems to be secondary relative to the money market rate, a more reasonable “neutral” or an equilibrium level of the key policy rate can be found only after either the key rate is brought below the interbank money market rate, or if Minfin’s FX purchases are significantly reduced so that the money market rate rises and exceeds the key rate. It looks as though the second option is not on the table, therefore an additional 25 bps rate cut seems reasonable.

The CBR’s aforementioned potential 50 bps rate cut can only preserve the status quo between domestic and global rates as the Fed is likely to orchestrate the same 50 bps cut in the coming months. Foreign investors already own over 30% of the Russian OFZs and the yields look too high for a country with low debt levels and no actual need to borrow at all as the budget and the current account are in surplus. The ruble exchange rate volatility is the major risk for investors, especially for those who entered the market when the US dollar was well weaker than 65 rubles. The ruble at 6667 per dollar or weaker may once again encourage additional foreign capital inflows, causing unnecessary ruble appreciation, bringing about extra volatility and increasing risks of higher inflation.

Therefore, cutting the key rate in the current environment not just seems supportive for economic growth alone, but should also be viewed as a measure aimed at keeping inflation less volatile, as it is expected to fall below the CBR target very soon.

Data provider: Cbonds

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