Russia's Wartime Economy Overheats as Interest Rates Rise

Russia's central bank is expected to raise interest rates beyond their record 21 percent on Friday, as policymakers struggle to tame inflation in what President Vladimir Putin has described as an "overheating" war economy, reports the Financial Times.

This move comes as Elvira Nabiullina, the hawkish governor of the Central Bank of Russia (CBR), faces mounting criticism from officials and oligarchs who argue that her aggressive rate hikes are stifling business. Her persistence in raising rates, even as inflation spirals out of control, highlights the impossible choices policymakers face during the war, according to senior Russian businessmen and economists.

"Either you have enormous spending, or a stable foreign exchange rate and a market economy," a former senior energy executive told the Financial Times. "You have to sacrifice one of those. You can't have it all at once."

The Russian economy is grappling with persistently high demand exceeding supply, while the CBR's tools to combat inflation are limited beyond high interest rates. This, coupled with low unemployment and weak productivity, is fueling concerns about inflation reaching as high as 10 percent by the end of 2024. The CBR itself estimates annual inflation at 9.6 percent, far exceeding its target of 4 percent.

The ruble has weakened by about 20 percent since summer lows, trading at around 103 to the dollar. This is attributed to sanctions limiting Russia's energy exports and ability to transact internationally. Meanwhile, unemployment hovers around a mere 2.3 percent as defense manufacturers operate around the clock, fueled by increasing budget spending, while the civilian sector struggles to keep pace.

The CBR itself acknowledged the strain on the economy in its latest report, stating that the economy is receiving "far more money than it can ‘digest’."

The CBR's interest rate hikes, which began in July at 16 percent, have drawn criticism from prominent figures, including Igor Sechin, head of Rosneft, and Sergei Chemezov, who leads Rostec. Sergei Mironov, head of a Kremlin-backed opposition party, went so far as to accuse Nabiullina of "sabotage."

Despite the criticism, Nabiullina, who has steered Russia through several economic crises, enjoys significant leeway from Putin, who has publicly acknowledged the challenges but continues to support her in private, according to sources cited by the Financial Times.

In his annual press conference on Thursday, Putin acknowledged "inflation" and "a certain overheating of the economy" but asserted that "the government and the central bank are already tasked with bringing the tempo down."

However, the former senior Russian official cited by the Financial Times suggested that Putin's bravado masked growing concerns about the sustainability of the war effort.

"He can hang on for two or three years like this. But he knows the economy can’t grow with these interest rates. It’s a disaster," the official stated.

Economists point to several indicators highlighting the deepening economic strain. One is the surge in wages for unskilled workers driven by a hiring spree in the defense sector. Some salaries rose by as much as 45 percent in the first half of 2023, according to Russian classifieds site Headhunter.

"Your welder was lured over to the defence factory for a huge salary," the former senior energy executive said to the Financial Times. "Now either there’s nobody to hire or you have to hike salaries, and how are you going to make money? Interest rates are so high that you can’t attract money and construction grinds to a halt."

This hiring spree, according to Elina Ribakova, a senior fellow at the Peterson Institute for International Economics, is focused on "throwing people at the front lines and to produce Kalashnikovs. That is not productivity growth."

The ruble's recent slide further indicates increasing pressure on the Russian economy as Western sanctions target Moscow in increasingly sophisticated ways. The recent blacklisting of Gazprombank, a key conduit for energy exports, by the US has further constrained Russia's access to the global economy and the SWIFT payment system, forcing importers and exporters to navigate complex and expensive workarounds for international transactions.

Ordinary Russians are bearing the brunt of the financial strain. Housing prices have soared by 30 percent since the war began, according to SberIndex, a data set compiled by Russia's largest state-owned bank. This, coupled with soaring mortgage rates and a halt to subsidized lending, has made homeownership a distant dream for many.

The confluence of these factors highlights the difficult choices facing Nabiullina, who has limited tools to combat inflation without jeopardizing the war effort.

"She could try to intervene into subsidised loans for the military-industrial complex. Nobody’s going to allow her to do that," Ribakova said. "That’s not the priority. The priority is stronger output growth and the