Monetary Policy of the Bank of Russia under Conditions of Dominance of Budget Expenditures

“To effectively combat inflation, the Bank of Russia needs an independent monetary policy – and precisely at this time when the independence of monetary policy is under threat. First of all, the boundary between monetary and fiscal policy should be clearly defined,” said Sergey Andryushin, Doctor of Economics, Professor and Chief Researcher at the Institute of Economics of the Russian Academy of Sciences.

 

In 2020-2021 (during the pandemic), leading central banks were convinced that they had solved the problem of inflation, and that it would always be within their established target (2.0%) – and therefore many of them did not see a big threat in the growth of budget and debt financing. But in 2022, the political and economic context in the world has changed dramatically. Inflation has risen in almost all countries (in September to 8.2% in the US, 9.9% in the EU, 10.1% in the UK). Therefore, central banks were forced to raise their base (key) interest rates (to 2.0% in the ECB, 2.25% in the Bank of England, and 3.0-3.25% in the US Federal Reserve). Under these conditions, the independence of central banks began to be questioned. Fiscal policy came to the fore and came to dominate over monetary policy, making the latter expansionary.

 

Risks of the Loss of Independence of the Bank of Russia in 2023-2025

Price stability in 2023-2025 remains the main goal of the Bank of Russia’s monetary policy. Low and stable inflation, all other things being equal, enables companies and the population to plan their activities better, contributes to increasing the availability of debt and equity financing, and protects the income of citizens and businesses from the unpredictable depreciation of the Russian ruble.

Against the background of the fact that annual inflation has been declining since August of this year, from 14.3% to 12.9% in October, the Bank of Russia decided at the end of October to keep the key rate at 7.5% per annum. This decision was connected by the Russian regulator with the low growth rate of consumer prices, as well as the current balance between inflationary and deflationary risks.

The dynamics of the economy and inflation in contemporary conditions have become significantly dependent on the parameters of the budget policy adopted by the government. But attempts to increase the potential of the economy through budget dominance and the establishment of an unjustifiably low key interest rate – which does not correspond to the macroeconomic situation – can lead to long-term negative consequences for price stability, namely an increase in inflation and a decrease in economic potential.

First, the Russian government might ask the Bank of Russia to cover the budget deficit by buying the country’s public debt – which means printing money to finance government spending. For example, in 2023, state domestic borrowing is planned in a volume of 1.5978 trillion rubles, more than 55% of the total budget deficit. At the same time, the average annual cost of servicing the state (municipal) debt in the medium term will increase markedly as compared to similar expenditures in 2022 – by approximately 119.3%.

Secondly, the Bank of Russia, in the context of growing macroeconomic instability, could maintain the unjustifiably low key interest rate at 7.5%, which will trigger further growth in lending and increase liquidity risks in the face of unjustified stimulation of domestic demand. All this will contribute to the growth of inflation and the rapid expenditure of accumulated money in state funds. For example, in the draft federal budget for 2023-2025, it is planned to reduce the funds of the National Welfare Fund (NWF) by 2.3 times, from 13.6 trillion rubles at the beginning of 2022 to 5.9 trillion rubles (3.5% of GDP) at the beginning of 2025.

Thirdly, in conditions of growing macroeconomic uncertainty – when it becomes difficult to determine the equilibrium real interest rate or the output gap, to catch structural changes in econometric models, or to assess the impact of non-monetary factors on inflation – the independence of the Bank of Russia may suffer greatly. As a result, it will be possible to switch to a more expansionary monetary policy in order to avoid political pressure from the government.

 

Measures to Increase the Independence of the Bank of Russia

To effectively combat inflation, the Bank of Russia needs an independent monetary policy – and precisely at this time when the independence of monetary policy is under threat. First of all, the boundary between monetary and fiscal policy should be clearly defined. At the same time, the Bank of Russia should not adhere to the principles of either broad coordination with the Ministry of Finance (Treasury), or the acquisition of additional powers (mandates) delegated to it by other ministries and departments.

First, a clear distinction between monetary and fiscal policy is best achieved if the Bank of Russia has limited powers focused on its main goal of ensuring medium-term price stability. Imposing additional goals, mandates, or powers on the regulator – such as ensuring economic growth, or financing the budget deficit and state programs – will undoubtedly increase the risk of abuses in monetary policy, which means that there will be a risk of budget dominance over price stability.

Secondly, ensuring the independence of the Bank of Russia will prevent the misuse of monetary policy in the interests of the government and the state budget. The goal of the Bank of Russia should have a clear and focused goal – the return of inflation to the level of 4%. Thus, the fulfillment of this mandate should become the main and only goal of the Bank of Russia in 2023-2025, making this mandate invulnerable to criticism and unfounded accusations.

Third, the guarantee of the independence of the Bank of Russia will mean the absence of an erroneous monetary policy, avoiding its underlying bias toward fiscal expansion. The Bank of Russia should be self-critical in its economic analysis, which should be centered on a quick and objective reassessment of changing data about both external and internal risks and factors.