Central Bank of Russia catches up with EM dovish monetary policy stance

What happened?

On June 19, during the regular scheduled meeting the Bank of Russia made a bold 100-bps cut to the key rate, the biggest reduction in five years, bringing it to a record low 4.5%. Therefore, the real rate, or the room left until negative rates based on current annual inflation, decreased to 1.5%, the lowest in more than four years. The move missed our expectations, as we projected a gradual and slow reduction. The Central Bank's decision was partly driven by a lag in pace of reduction behind other emerging markets (EM) regulators, which have already lowered their benchmarks by an average of 250-bps year-to-date.

The CBR’s head governor Elvira Nabiullina reinforced her earlier tone, stating that the bank will weigh further cuts if the situation develops in line with the baseline forecast, that is CPI will decline further and the second quarter will see a sharp GDP decline.

Our forecast:

We believe that further cuts will be within a 50-bps range, so we expect the rate to decline to 3.25% by the end of the year (one additional 50-bps cut and two series of 25-bps cuts), down from previously projected 4.5%. Therefore, we expect cuts at the upcoming meetings on July 24, September 18, October 23, and December 18. We believe that the CBR’s additional cuts will be within 150bps range this year, given that the bank isn’t ready to consider a negative real rate. Even if the 12-month CPI falls to 2.5% y-o-y, the nominal rate is unlikely to drop further by 200 bps.

Instant market reaction and our expectations

As the OFZ yields are concerned, such big cut wasn’t fully priced in, and the long note price advanced 0.5% during the session. Based on our end-of-year forecast, the mid-term OFZ yields could reach 4.5%, while on the long curve – 5%, which means a price upside of 3% and 10% respectively. We reaffirm our USDRUB end of the year forecast at ₽65-67.

Why are EM Central Banks have been actively cutting rates and will continue to do so?

1. Limited fiscal potential

Since the beginning of the year, the biggest cuts have been made by the EM countries, which have largely capped their fiscal stimulus to GDP ratios. Based on planned fiscal spending until 2021, Russia’s ratio is just under 5%, which is slightly higher than in other emerging markets and twice as low as in developed countries.

The most vulnerable economies, countries facing the highest risk, or already in default have been leading in terms of key rate cuts. For example, Argentina has made the largest rate cut year-to-date - by 30%, Ukraine - by 7.5%, Turkey - by 3.8%, South Africa - by 3%, other countries - about 2%, Russia ranks 10th with a 1.8% cut, which is slightly above the world average.

2. Global CPI drop

Global deflation, witnessed since mid-2018, picked up significantly amid the coronavirus. Global CPI has fallen by an average of more than 1.5%, mainly in developed countries: Canada (-2.6%), the USA (-2.2%), Switzerland (-1.5%) and Europe (-1.2%). Thailand recorded the largest CPI decline of over 4%. Consumer spending without fiscal stimulus will fall even as global economy reopens - global fiscal stimulus has already reached about $10 trln, with 70% accounting for the U.S., Europe, and Japan. What is important, and the Central Bank says little about, is a sharp rise in production prices to the level of early 2019, which is not translated into consumer inflation due to falling imports, cash income and lower real consumer spending capacity going forward.

Other important comments during the press conference:

Neutral rate revision: The Central Bank does not rule out that it will adjust its view on the neutral range (currently at 2-3%) as part of the July macroeconomic bulletin. That said, the regulator does not expect sharp fluctuations, as the neutral rate below 5% is not considered.

The real rate to remain positive: Negative real rates are not expected. CBR’s methodology of real rate calculation is based on the 12-month expected inflation.

Inflation as a key indicator: Disinflationary pressures prevail and will continue to do so. In August and September, seasonal deflation is expected due to falling fruits and vegetables prices. At the same time, annual inflation may pick up in within the next months due to the low base effect. According to the Central Bank's assessment, the peak of such growth may be reached in February 2021. The updated economic forecast, including the expected consumer price index in the next year, will be given in the framework of the next benchmark meeting on July 24.

Rates will remain low at least until the end of 2021. The CBR's further interest rate strategy will still be based on the current balance of significant factors. The regulator is not yet ready to announce the end of the easing cycle. On the contrary, it has given a clear signal for possible further rate cuts. At the same time, such big cuts are unlikely in the future, as these are rather unusual tools. Monetary easing duration will also depend on global central banks’ policy. The CBR may therefore signal that low rates will remain in place in Russia at least in the next 18 months.

Russia's borrowing policy. The Ministry of Finance has plenty of room to increase state borrowing. The Bank of Russia does not see any problems with the borrowing programme and believes the current debt costs are comfortable.

Economy outlook. Nabiullina suggested the 2Q contraction will be worse than 8% year over year, due to the longer impact of restrictive measures, but not beyond 10%.