Budanov's forecast in action. Will record key policy rate hike help Russia?

Russia's Central Bank raised its key interest rate by 200 basis points to 21% on Friday, in response to rising inflation and high inflationary expectations among the population and businesses.

This rate is the highest since March 2022, when the Central Bank raised it to 20% to stabilize financial markets following the full-scale invasion of Ukraine. The rate was subsequently lowered to 7.5% in 2023 but has since been increased eight times.

The current rate of 21% is extremely high for the economy. The Central Bank of Russia acknowledges that its decision is a reaction to rising inflation and high inflationary expectations among the population and businesses. The bank has also warned of the possibility of further rate hikes and plans to curb inflation by 2026.

This outlook is even more pessimistic than previous data from Ukrainian military intelligence. On September 14, the head of the Main Intelligence Directorate of the Ministry of Defense of Ukraine, Kyrylo Budanov, reported that Russia would face financial and economic problems by 2025 if it continued to spend the current amount of funds or more on the war.

"Approximately in the summer of 2025, the negative impact on the economy will become very noticeable for their country," the spymaster said.

However, Russia has not only planned to continue its current level of war spending but also intends to increase it significantly.

Does Russia have the capacity to sustain this, and what does the Central Bank's decision really indicate? LIGA.net provides a brief summary.

Russian inflation out of control

Actual inflation in Russia significantly exceeds forecasts, and domestic demand continues to outpace supply, further driving up prices.

"The labor market remains tight. Unemployment is at historic lows. The shortage of labor resources is growing across a wide range of industries. Wage growth continues to outpace productivity growth," the Bank of Russia describes the situation in the Russian economy.

The consequence of raising the interest rate is expected to be an increase in the cost of loans for businesses and the population, a decrease in consumer demand, and a slowdown in economic growth. On the other hand, the Central Bank of Russia hopes to curb inflation through these measures.

However, the rise in prices in the country is driven by massive investments in the military-industrial complex and record payments for service in its army.

This is exacerbated by problems with importing goods due to sanctions and difficulties in cross-border financial settlements.

"We have a colossal imbalance between what the economy can actually produce and what people can buy in stores: food, clothing, household appliances, electronics, cars, spare parts, which we do not produce ourselves, as an economy of a 'gas station,' a raw material colony and a raw material appendage of China, and the finances that the authorities are pouring into the economy, which stimulates demand for these goods," explained Russian economist Vlad Zhukovsky.

War spending in Russia's budget: Records that are not enough

The regulator's tight monetary policy is leading to a cooling of the Russian economy. Meanwhile, inflation is accelerating. Spending large amounts on the war is driving up Russian prices. Here, the Central Bank's decision on the rate has little impact—more likely, it reflects its inability to do anything. The increase in the rate above the expected and record 20% is not accidental and occurred after the announcement of the federal budget projects for the next (2025) year.

In it, as noted by Russian economist Vladimir Milov, the plans for military spending are record-breaking.

However, even these record figures do not reflect the real needs of the Russian army in terms of money. At least to continue combat operations at the current intensity.

For example, if the increase in military spending in 2024 compared to the previous year is 68%, and in 2022-23, the annual increase was 35-40%, then in 2025, an increase of 26% is planned—from 10.8 trillion to 13.5 trillion rubles ($110.9 billion to $138.6 billion). Even official inflation in Russia for 2024 is 8-9%. Given this, real military spending next year will increase by only 15-16%, if not less.

To meet all the needs of the Russian army, these funds will not suffice.

"This is simply not enough," Milov argues.

Meanwhile, Russia is already experiencing a significant budget deficit, a sharp increase in expenditures on servicing the national debt, and the depletion of the so-called liquid part of its National Welfare Fund (money plus gold stored in the accounts of the Ministry of Finance in the Central Bank), from which the shortfall of funds can be covered.

The remaining options are:

– Further tax increases;

– High real inflation rate;

– Increase in domestic borrowing.

In Russia, there are already serious discussions about how to force the population to pay for the war with their savings: voluntoldly "transferring" them from savings to the accounts of commercial pension funds. Then the funds will buy internal loan bonds—effectively transferring money to the budget.

It is no surprise that in this situation, the population and companies continue to take out loans and buy everything they can while they still can, and believe that inflation will remain high. No one pays attention to the key rate—whether it is 19% or 20%—and its further impact on increasing interest rates on loans.

"People expect inflation to be high, so they take out loans even at exorbitant rates, saying: 'Oh well, inflation will devalue everything anyway,'" notes another Russian economist, Igor Lipsits.

At the same time, he points out that against the backdrop of record increases in war spending in the plans for the next year, there is a significant reduction in social spending. This will occur against the backdrop of rising housing and utility costs, indirect and direct taxes.

The Russian economy is inexorably moving towards stagnation and stagflation—a situation in which economic decline and a depressive state of the economy (stagnation and rising unemployment) are combined with rising prices—inflation.

In 2022, the stabilization of the Russian economy was aided by a significant increase in energy prices—oil and gas. In this and the following years, a noticeable increase in prices for these commodities is not planned. On the contrary, current forecasts for 2025 for oil are for a decrease in prices.

"The fact that the economy will defeat Russia is practically the only bet, the only glimmer of hope in the clouds. Because of the war, there is such a destruction of the life of the Russian people that it is already beginning to breed discontent among the population. And when discontent arises, the authority of the leader is undermined. And at this moment, the elite may change something... Many people in Russia used to love Putin very much... the picture is not the same now. Because he takes away (prosperity -ed.) and does not give, ruins life. The people are accumulating a silent resentment. It has not yet spilled over into any serious strikes. But it will grow, precisely from utilities, from empty stores, and will spill over into discontent. Then the people and the Russian elite will begin to think: 'The tsar is bad, the tsar is weak, it is time to change the tsar,'" says Lipsits.