Fighting Inflation Needs to Be a Top Priority

Among the G-20 countries, representing 80% of global output, Russia stands out as an anomaly in at least one way: Russia continues to have a problem with high rates of inflation.

Last Thursday it was announced 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 rapid expansion of government spending, some of which of questionable merit.

The annual rate rose to 13.4%. Consumer prices rose 2.4% from December, when they advanced a monthly 0.7%. Food prices gained 15.9% in the year through January, while the cost of services such as electricity and heat rose 16.9%. Inflation has barely begun to reflect the impact of the ruble devaluation, so inflation will probably accelerate this month and in March.

Russia is the outlier among the world's major economies. Elsewhere the collapse of credit, sluggish real activity and lower commodity prices have dampened inflationary pressures. The latest IMF projections show that in emerging and developing economies, inflation is expected to subside to 5? percent in 2009 and 5 percent in 2010, down from 9? percent in 2008.

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 US, the EU, China, and practically all other emerging economies. At least then what was happening in Russia could be interpreted as an irresistible consequence of a global price surge.

Now Russia stands alone among the G-20 (Ukraine's price performance is even worse but it is not in the G-20). The Economy Ministry currently estimates inflation could be as high as 13 percent in 2009. In fact the annual rate for last December was 13.3%, so they seem to anticipate very little change in the situation. The latest IMF projections for this year show no other G-20 country with expected inflation in 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%, 7.3% and 7.9%, respectively. The IMF projects Russian inflation at 12.6%.

The irony is that Russia has decoupled at a time when many advanced countries are seriously worried about the specter of deflation.

In Russia, 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 authorities at this juncture. After all, output, unemployment, the budget, balance of payments, and the ruble exchange rate should arguably be the policy focus. 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. Just as we have learned with surprising abruptness in recent months how intimately Russia is linked to the global economy, 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 US dollar. Both values could remain as volatile in future as they have been in the past year.

Inflation is largely within its control. It must be the immediate priority. Monetary policy should be tightened and interest rates 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 counter-intuitive at a time when everyone else in the world is throwing money at their problems. The contrast is actually more nuanced. Substantial public resources are being directed at macroeconomic stabilization and support for the banking sector. Even with some trimming, as a percent of GDP, the shift in the budgetary stance in Russia is likely to be more than double that, say, of the US between mid-2008 and mid-2009

The belated implementation of a much tighter approach to liquidity will not only dampen price rises; it 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 owing to rising prices. No amount of reserves, not even Russia's ample stock, 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. However, 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 domestic households and companies. With less of a differential with 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.

Signs in recent days seem to indicate some tentative steps by the CBR in the direction suggested here. Much more should 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 CBR to the banks so, 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. They 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 Russian 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 recent depreciation of the ruble, work through the system in coming weeks, we could see a big and pleasant drop in inflation - and even a strengthening of the ruble - in a higher interest rate environment. It is really the choice of the Russian central bank and ministry of finance. This is the real test of their courage to do what is right for the country despite the short-term costs and political pressures.