Why Russia's central bank has stopped cutting rates

When the Bank of Russia's board meets today, it is expected to leave its key interest rate at 14%, a pause that would end an easing cycle of more than a year in which a record 21% rate was brought down by a series of cuts. To the market the hold is a foregone conclusion. The interesting thing is not the number but the reason.

A normal central bank pauses when its inflation target is within reach. Russia's is not. Annual inflation is running well above the 4% target — the central bank predicts it will reach 6.3% by the end of September and 6–7% for the year — yet the bank cannot keep fighting price rises at the expense of an economy at war. The pause is really an admission that it no longer sets the price of money by itself. The government's budget does.

Economists call this fiscal dominance: the condition in which a state's need to borrow outweighs whatever a central bank does to restrain it. Russia's federal budget deficit reached 6.455 trillion roubles, or 2.8% of GDP, by the end of July, the product of military spending that will not be cut. The central bank's own communications enumerate the inflationary pressures — the deficit, wage growth running ahead of productivity, dearer energy — and every one is a description of war, translated into economics.

The specific pain is fuel. Ukrainian drone strikes on Russian refineries have knocked out enough capacity to spread shortages across nearly all of the country's regions and push up pump prices, and the central bank calls the result a "supply shock" that will fade only slowly. A supply shock is exactly the sort of event a monetary authority can do little about — it cannot drill refineries — leaving the bank with a choice between feeling inflation and feeling a recession. It has chosen a waiting game: rates high enough not to add fuel, yet too high, it fears, to cut further.

Investors who glanced at Russia's second-quarter numbers could be forgiven for seeing strength: GDP grew 1.3% year on year, reversing a 0.2% contraction in the first quarter. The central bank reads none of it as recovery. It cut its full-year forecast to 0–1% and lowered its fourth-quarter projection to 0.0–1.5% year on year, while its governor says companies expect demand to slow. The components of the rebound explain why. The second quarter enjoyed a calendar quirk — about 5% more working days than a year earlier — and a jump of roughly 40% in state procurement. Much of the "growth" is war, booked as growth.

None of this means collapse. The rouble is managed, some output is real, and a war economy can grind on for years, at the price of living standards. But for a retail investor the episode is a useful study in what an inflation target is worth. A target is credible only when the institution behind it holds an effective veto over inflation; Russia's central bank, like those of other fiscally dominant states, has lost that veto. The key rate has become an output of the war budget, not an instrument against it.

The immediate relevance for an American retail investor is narrower but real: Russia's refining troubles are a genuine price force in global diesel and petrol markets. The deeper point travels further. When you ask of any central bank who is really setting the price of money, the answer is usually the budget standing behind it. Russia has stopped pretending otherwise.