Turning the Russian petro-monetary transmission mechanism upside-down
Big news out of Moscow today - not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of Elvira Nabiullina effectively let the ruble float freely. The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble's slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the "defense" of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble. It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR's decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make. Elvira has turned the petro-monetary transmission mechanism upside-down The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general. Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9. When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission - and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:
If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky. So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will "import" monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) - which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions. Lets take the case of the People's Bank of China (PBoC). If the PBoC ease monetary policy - increase monetary supply growth - then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth. Hence, causality runs from the monetary policy of the monetary superpowers - Fed and the PBoC - to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated. I have also discussed this before:
If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely. Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting. Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP). Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.If today's announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 - moving from a pegged exchange/manage float regime to a floating exchange rate. This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty - so it will be her rather than the Federal Reserve and the People's Bank of China, who determines monetary conditions in Russia. Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia. One can of course be highly skeptical about the Russian central bank's ability to conduct monetary policy in a way to ensure nominal stability - there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target - either an inflation target or better a NGDP level target. Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure. PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.