Will One of the Last Orthodox Central Banks be the First to Hike Rates?

Recent inflationary developments in Russia, including recent upside surprises in inflation and rising inflation expectations (Figure 1), have prompted the market to wonder whether the CBR will be one of the first central banks—among those not dealing with idiosyncratic issues—to hike rates in the aftermath of the pandemic, possibly within the year.

FIGURE 1: RUSSIA’S RESURGENCE IN INFLATION AND INFLATION EXPECTATIONS

A rate hike in 2021 is a close call. We think the rate-cutting cycle is over and the CBR’s hawkish rhetoric will increase, but the uncertainty about the COVID recovery in 2021 may give the CBR pause. The uncertainty is also compounded by the new U.S. administration’s still unspecified policy towards Russia, which will especially affect the exchange rate on the ruble (RUB). On a fundamental basis, the RUB should be one of the strongest EM currencies, but geopolitical events and uncertainty, i.e. potential future sanctions from the West, have prevented it from joining the recent rally of many EM currencies.

The exchange rate strongly influences inflationary expectations in all countries, and Russia is no exception. The CBR has adopted a “no FX intervention” policy (unless for exceptional events), in line with the adoption of an inflation targeting regime. And there is a clear correlation between inflationary expectations and the RUB exchange rate in recent years, as depicted in Figure 2.

FIGURE 2: THE TIGHT RELATIONSHIP BETWEEN THE RUBLE AND INFLATION EXPECTATIONS

In turn, inflationary expectations play an important role in the CBR’s decisions (Figure 3). The recent divergence between monetary policy and inflation expectations is the anomaly and not the norm, thus adding to the speculation of whether the CBR will possibly be one of the first, non-idiosyncratic central banks to hike its policy rate.

FIGURE 3: RUSSIA’S MONETARY POLICY RATE AND INFLATION EXPECTATIONS

A Temporary Blip…

While it might be nice to credit the CBR’s orthodox policy with its success in achieving its inflation target, more temporary factors are likely at play. The recent increase in actual inflation is a consequence of temporary disruptions in the supply of goods (particularly food items) and the RUB’s recent relative weakness amid geopolitical uncertainties. The Russian administration has taken measures to limit the price increases for certain types of food, and these measures might have some impact in controlling inflation in the short run. In the longer run, barring major negative weather developments, we think that food supply will return to normal, thus bringing inflation under control by the end of the year.

The crucial variable, though, is the exchange rate, and we think the RUB is poised for appreciation in the coming months as the current account surplus remains sizeable on the back of resurgent oil and commodity prices combined with some import restraint due to a slow economic rebound.

If major negative geopolitical events remain at bay, we also expect some inflows in the local bond market (OFZ). Foreigners hold 23.7% of the OFZ outstanding, down from 34.9% in February 2020, when the pandemic’s effects began washing over the markets. These inflows could provide additional support for RUB appreciation.

In conclusion, for most of 2021, we see year-over-year inflation hovering around the CBR’s 4% inflation target and then dropping between 3.5%-4% by the fourth quarter. In this scenario, the CBR will remain on hold, likely for the entire year, while adopting more hawkish rhetoric, thus supporting the RUB and reigning in inflationary expectations.

Therefore, for the time being, we prefer the RUB-denominated inflation-linked local bonds over OFZ bonds. And for Eurobond investors, our expectations for the CBR’s stance might provide a reassuring reminder of its status as one of the last remaining orthodox central banks.

This material reflects the views of the author as of January 20, 2021 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.