Putin’s hopes for monetary miracles
There is a lot of focus on what Russian President Vladimir Putin is saying these days. However, it is mostly about geopolitics and much less about his views on economics and particularly on central banking. However, I came across some interesting comments from Putin on monetary policy, which quite well illustrates some of the problems with his – or rather his lack of – economic thinking. This is from a recent article from Reuters:
Russian President Vladimir Putin told the country's top finance and economy officials on Wednesday that the current forecast for gross domestic product this year was unacceptable. "I will again stress that the existing growth rates and those forecast by the government cannot satisfy us," Putin told Central Bank Governor Elvira Nabiullina, Finance Minister Anton Siluanov, Kremlin economic adviser Andrei Belousov and others. …The weakening rouble, which has lost more than 10 percent against the dollar so far this year to trade at all-time lows , is also putting the central bank's goal of 5 percent inflation this year in jeopardy. "(We need to) ... keep inflation at an acceptable, low level," Putin said. He did not give details.So Putin wants higher growth and lower inflation. Well, that is just great. Lower inflation and higher growth would certainly be great for Russia. The problem of course is whether the Russian central bank can deliver this? Anybody who studied the AS/AD framework knows that monetary policy cannot deliver what Putin wants. The only way to get lower inflation and higher real GDP growth is through a positive supply shock and we all know that the central bank – either the Russian or any other any other central bank in the world – cannot control what happens to the supply side of the economy. CBR governor Nabiullina can fully control nominal spending (aggregate demand) in the Russian economy, but she has no powers to control aggregate supply. Unfortunately for her the Russian economy is presently experiencing a very significant negative aggregate supply shock – mostly due to capital outflow related to Putin’s de facto annexation of Crimea. We can understand this negative supply shock by focusing on a number of different – but related - factors, which should be seen as part of the aggregated supply shock feeding through the Russian economy at the moment. First of all the we are presently seeing massive capital outflows out of Russia as foreign investors are reducing exposure to the Russian economy and Foreign Direct Investments into Russian has probably come to a “sudden stop”. Lower investments obviously mean less capital accumulation and hence lower productivity growth. This of course is a negative supply shock. Second, as a consequence of the geopolitical developments investors are undoubtedly seeing more of what Robert Higgs have called “regime uncertainty”. Will Russia become a more closed economy in the future? Will government come to play even bigger role in the economy and will we see even more regulation and corruption? All these factors are impacting investments – both foreign and domestic - negatively. Third, the massive capital outflows have pushed the Russian rouble weaker. As a result import prices are rising significantly. That is increasing input costs in Russian industry and is hence also a negative supply shock. Not only are these factors likely to be very negative, but they are likely also fairly permanent in nature and more importantly the Russian central bank can do very little about it. The negative supply shock is illustrated in the graph below. The three factors described above are all adding up to pushing the Russian Aggregate Supply (AS) curve to the left. The result is of course that real GDP growth drops from y to y’ and that inflation increases from p to p’. This is not exactly what the doctor – or rather president Putin – ordered. So now governor Nabiullina can chose to ignore one of two demands from Putin. Either she tries to lower inflation or she tries to spur real GDP growth. However, if the shock to aggregate supply is permanent then she will not even be able to push up real GDP growth – at least not for long as inflation expectations are likely to “catch up” with any monetary easing fast. She can, however, deliver lower inflation by tightening monetary conditions and this is of course exactly what she has done. The problem is of course that that comes at a cost – likely a large cost – of killing growth. This is also illustrated in the graph above. When monetary conditions are tightened significantly (CBR as likely intervened for as much as USD 20bn in the currency markets over the past month and increased it key policy rate by 150bp) then the aggregate demand (AD) curve shifts to the left – pushing inflation down to p’’, but also further reducing real GDP growth to y’’ from y’. In fact most economists who are covering the Russian economy have recently been revising down their growth forecasts for the Russian economy in 2014. And goes for myself as well and I am quite convinced that the Russian economy will go into recession and experience negative quarter-to-quarter GDP growth in at least the next couple of quarters. Former Russian Finance Minister Alexei Kudrin agrees. Mr. Kudrin a couple of days ago said that he now expect a Russian recession in 2014 (See here). So why is the CBR tightening monetary policy when it so obviously is likely to lead to a sharp slowdown in Russian growth? I most say I continue to be puzzled by Emerging Markets central banks around world, which over the past year have moved to sharply tightening monetary conditions to curb exchange rate depreciation despite these central banks officially operate floating exchange rate regimes. The most likely explanation in my view is that policy makers – on strong pressures from governments – are politically motivated by the fact that currency weakness is see as being politically embarrassing for local rulers such as Russia’s President Putin or Turkey’s Prime Minister Erdogan. The paradox here is that this fear-of-floating likely is doing a lot more damage to the Russian economy at the moment than any of the sanctions, which this week have been introduced by the EU and the US.