Interest rate hike just a sticking plaster for Russia’s war

Further tough decisions will be needed while the Kremlin continues to spend large sums on its Ukraine invasion

Protracted wars are costly and cause economic damage. Ancient Rome discovered that, as did the US in the 1960s when the conflict in Vietnam was one factor behind pressure on the dollar that led eventually to the breakup of the Bretton Woods fixed currency system.

The decision by Russia’s central bank to raise interest rates from 8.5% to 12% to defend the plunging rouble is the latest example of this age-old truth. Eighteen months into the war with Ukraine, Russia’s current account surplus is shrinking and inflationary pressure is growing. The currency is taking the strain, and the trigger for Tuesday’s emergency move appears to have been the rouble hitting 100 to the US dollar on Monday.

Thus far, policymakers in Russia have made a decent fist of keeping the show on the road, despite attempts by the west to impose an economic blockade. The International Monetary Fund has revised up its forecasts for growth this year, and official figures show the economy expanded by almost 5% between the second quarters of 2022 and 2023.

The Russian economy is now showing clear signs of overheating as it runs into capacity constraints. Inflation over the past three months has been running at an annualised rate of more than 7% – well in excess of the 4% official target.

In a sense, this is inevitable given the Kremlin’s decision to continue spending large sums of money on the war. That has meant running the economy hot. Attempts to support living standards to maintain support for the war among ordinary Russians have added to upward cost pressures. Sanctions are starting to bite harder now that falling global energy prices have led to a sharp reduction in exports.

Russia’s central bank will be hoping the latest tightening of policy has a similar impact to the “shock and awe” announcement shortly after the invasion that interest rates were being raised to 20%. That helped stabilise the currency, which at one stage last year hit a low of 150 roubles to the dollar. So far this year, it has fallen by 30%.

The feeling among analysts is that the move to raise official borrowing costs is a sticking plaster solution to a problem that will only be solved when the fighting stops. “As long as the war continues it just gets worse for Russia, the Russian economy and the rouble,” said Timothy Ash, strategist at RBC Bluebay Asset Management.

“Hiking policy rates won’t solve anything – they might temporarily slow the pace of depreciation of the rouble at the price of slower real GDP growth – unless the core problem, the war and sanctions are resolved.”

The message is clear. Further tough measures will be needed to slow the pace of capital outflows, reduce the current account deficit and improve Russia’s financial position. That means even higher interest rates, cuts in non-military spending and a slowdown in the domestic economy. As has been the case many times in the past, war will mean hardship for the Russian people.