Incurable Disease: Accelerating inflation is the flip side of ‘military Keynesianism’ and economic growth under the conditions of sanctions and the 'special military operation'

Weekly price growth in the second half of June significantly intensified, projecting double-digit inflation rates on an annual basis. For the first time since December 2023, ordinary citizens have also noted this acceleration. Business costs and price expectations are rising in all major segments.

The main reason for the acceleration of inflation is the intense growth in consumer demand, which is supported by rising household incomes and high levels of lending. The Central Bank's refinancing rate of 16% is not exerting a sufficient restraining influence on these factors.

Income growth is driven by high demand for labour in the defence sector and strains in the labour market that are exacerbating the ongoing exodus of workers. At least half a million people have been drawn out of the economy over the past year and a half by the ongoing hostilities in Ukraine.

At the same time, economic and income growth is not supported by a corresponding increase in domestic production in consumer sectors. Additionally, it cannot be compensated for by imports, which remain 10% lower than a year ago.

Most analysts believe that the Central Bank will be forced to raise the rate further at the next meeting. However, the problem is that its level is virtually incapable of influencing the factors creating imbalances in the Russian economy under conditions of war, sanctions, and fiscal stimulus.

In the week from 18 to 24 June, Rosstat recorded the fastest price growth since the beginning of the year – +0.22%. Such growth rates, projected over a year, indicate double-digit inflation figures. This also means that the cherished target of 4% annual inflation will be reached by the end of June, based on the half-year results (3.82% from the beginning of the year to 24 June).Rosstat's weekly monitoring is based on a limited range of goods, and the actual rate of price growth may be slightly lower, but the trend is obvious: after a period of slowdown, inflation is once again on the rise. The monthly increase in the price index is unlikely to be lower than May's (0.74%), given that by 24 June, the increase had already reached 0.58%. However, the summary of the 6 June key rate discussion at the Central Bank uses a more cautious formula: 'the decline in inflationary pressure has stalled'. This is because some Central Bank experts consider the inflation spikes in April-May to be more a manifestation of volatility rather than a sustainable trend. They expect that with a longer lag than initially anticipated, the high current rate of 16% will still have a ‘cooling’ effect on the economy.

Monthly price growth (annualised), 2021-2024, %

In June, for the first time since December 2023, the acceleration of observed inflation was also noted by citizens in an InFOM survey (they estimated inflation at 14.4% against an estimate of 14% in May); the upward trend in inflation expectations also continued, but at a much lower rate (expected inflation in April was 11%, in May – 11.7%, in June – 11.9%). Additionally, there was a slight deterioration in the assessments of material well-being, particularly an increase in the proportion of families identifying as the poorest category ('not enough even for food' and 'only enough for food') increased from 24% to 28%. This is also a consequence of inflationary pressure – price growth is stronger in the food segment.

Costs and price expectations of businesses are rising in all major industries except for intermediate goods production, according to the June survey of enterprises by the Central Bank. Among the main reasons for the increase in costs, businesses cite higher labour costs, increased purchase prices for raw materials, supplies, and components, as well as rising transportation expenses.

The Central Bank attributes the main cause of accelerating inflation and rising inflation expectations to a consumer boom, fueled by both rising wages and increased lending. Real incomes continue to grow due to the acute labour market shortage and high demand for labour from the government procurement and defence industries. In the first quarter, real income growth, according to Rosstat, was 5.8% year-on-year, while at the end of last year, the government had expected only +2.7% for the entire year. Rising incomes allow the population to simultaneously increase both savings (encouraged by high deposit and savings account rates) and borrowing.

‘The increased incomes of households and businesses allow them to attract more and more borrowed funds, and the banks' large capital stock allows them to continue to increase lending’, the Central Bank said in its summary of the rate discussion. In other words, under the current mechanism, the high rate does not lead to a decrease in consumer lending. The June issue of the Central Bank's report on the state of the banking sector shows that household deposits in banks increased by a significant 1.3 trillion rubles (+2.6% year-on-year after +2.1% in April) in May. Central Bank analysts call such dynamics atypical – savings usually do not grow during the vacation season. Overall, since the beginning of the year, the increase in account balances has already amounted to 4 trillion rubles, compared to 1 trillion during the same period last year.

At the same time, the growth of consumer loan issuance is accelerating – or at least not declining. In May, the increase was 2% (more than 290 billion rubles) after 1.8% in April. Mortgage lending also accelerated – from 1.4% to 1.7%. In May alone, nearly 550 billion rubles worth of mortgage loans were issued. In recent months, the growth of consumer lending has been significantly driven by the credit card segment, note Central Bank analysts. This segment is the least sensitive to the key rate level since borrowers strive to stay within the interest-free period.

The current rate of 16% does not affect either the dynamics of lending or wage dynamics, the trigger for their growth is 'state demand', as well as the current structural and conjunctural features of the labour market. In particular, the recruitment of contract workers for the ‘special military operation’ in the first half of the year diverted another 120,000-180,000 workers from the market (→ Re: Russia: People vs. Drones); overall, the war has seemingly drained more than 0.5 million workers from the productive sector (0.3 million mobilised, plus contract soldiers from 2023 and the first half of 2024). Anti-migrant raids and stricter entry rules for migrants from Central Asia have weakened the compensatory effect of migration inflows (→ Re: Russia: Authoritarian Dysfunction).

Another peculiarity of the 'military reality' is also a factor of pressure on the domestic market during and before the holiday period. Before the war, citizens' funds were diverted to foreign tourism. In the summer of 2022 and even 2023, this factor was not as noticeable since income levels had decreased at that time. However, their rise at the end of 2023 and the beginning of 2024 is leading to significantly greater vacation spending pressure on the domestic market. In June, a significant contribution to the overall price increase came from the rising cost of services related to domestic tourism, according to Rosstat. For instance, the average price of an economy-class airfare has soared by almost a quarter since the beginning of the year, and the average price of accommodation in various hotels, hostels, and boarding houses has increased by 11–17%.

‘The growth in consumer demand still exceeds the capacity to expand supply, and this is the main factor behind the increased price growth’, agree all participants of the June Central Bank rate meeting. In other words, the acceleration of inflation is fundamentally driven by the effect of economic militarisation, or ‘military Keynesianism’: the increase in the production of non-consumer goods boosts employment and wages, but the resulting rise in demand is not matched by an increase in the production of consumer goods. Furthermore, the high rate seemingly also contributes to the low response of the consumer sector to the increased demand.

Under normal conditions, the response to this imbalance should be an increase in imports. However, this is not happening under the current conditions. According to a preliminary estimate by the Central Bank, imports in May 2024 were again 10% lower than in May 2023. This ratio has been consistent for all the first five months of 2024: imports amounted to $113.5 billion compared to $126.3 billion in January–May 2023. Such a decline is particularly striking against the backdrop of economic growth on one hand and the rising costs of imports on the other. In the second half of 2021, when the economy was growing at similar rates, recovering from the COVID-19 pandemic, the average monthly import volume was $27.1 billion (compared to $22.3 billion at the beginning of 2024). Considering dollar inflation (nearly 20%) and the increased costs of importing into Russia due to sanctions, the gap in physical import volumes is impressive. According to SberCIB, imports are now almost 30% lower than they should be, given economic growth, dollar inflation, and several other factors.

Imports to Russia, January-May 2023/2024, billions of USD

Meanwhile, in consumer sectors, we do not see growth that could confirm the import substitution hypothesis. The reasons for the constraints on import growth are non-economic—they are stalling due to payment issues. Since the beginning of the year, foreign banks have been rejecting many payments, fearing secondary sanctions. Deputy Chairman of the Central Bank Vladimir Chistyukhin urges companies to use any alternative payment methods: ‘If there are no normal settlements for foreign economic activities, for our export- and import-dependent country, it is simply a disaster’. And Chistyukhin is right.

The interim June data on inflation will strengthen the position of those who consider the pro-inflationary trend to be a stable factor that requires an adequate response, i.e. a rate hike. In these circumstances, the majority of analysts see an increase in the key rate to at least 18% at the next meeting of the Central Bank's Board of Directors on 26 July as almost inevitable (see forecasts from SberCIB, Sinara, Sovcombank, PSB, MMI). A rate hike to 20%, as in March 2022, no longer seems unrealistic. However, the real issue today is not the dilemma of whether to raise the rate but rather how and whether the new hike will impact the overheated economy. The rate level will not affect the dynamics of budget inflows into military and quasi-military sectors, the labour market situation, import settlements, or restrictions on foreign travel for Russians. The Central Bank likely realises that it is prescribing the wrong medicine for the economy and is doing so simply because it has no other options.