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NES Professor Oleg Shibanov spoke in the “Economics Out Loud” podcast about how a central bank can support the economy. Can it accelerate economic growth? When it raises key interest rate – what does it mean? What are the consequences of freezing reserves? We are sharing the main takeaways of the talk.
Changing the key interest rate is one of the main instruments to impact the economy in any Central Bank’s toolkit. By lowering the rate, it can significantly increase business activity, and by raising it, it can slow the economy down. The regulator uses this instrument depending on the type of crisis. In 2020, the Bank of Russia (Russian Central Bank) cut rates quite a lot, because it was clear that there was a temporary decline in demand, and it was necessary to encourage people to borrow, it was necessary to try to help companies to maintain employment and investments. In 2022, the situation is different. People and companies want to switch into US dollars, as it was in 2008-2009, and the Central Bank is trying to influence this trend by raising the rate to 20%. Following the Central Bank, commercial banks raise rates on deposits and loans, thus increasing the attractiveness of ruble investments and incentivizing the population to save more and borrow less. Meanwhile, demand in the economy slows down and prices do not rise as fast as they otherwise would.
Unfortunately, the Central Bank does not have a magic wand. This transmission mechanism does not work instantly. Changes in the key rate affect deposits faster and loans slower. Usually, the full effect of the rate change is felt after 3-6 quarters. Most likely, we will feel the full impact of the increase in the key rate in the second half of 2022.
However, in the situation when international reserves (in US dollars and euros) are frozen, raising the key rate to 20% may not be enough to sufficiently reduce the pressure on the ruble. It is possible that the Central Bank will have to raise rates even further.
The Central Bank can also influence lending by regulatory methods. One of the ways to do it is through changes in the Lombard List - a list of securities that the Central Bank is ready to accept as collateral when providing loans to banks. The other way is through the reserve requirements for commercial banks. In times of crisis the Bank of Russia can use this buffer and open access to this liquidity for commercial banks.
As of 2020, the ruble was a free-floating currency. Only 31 countries have this type of exchange regime. Today, however, the free floating of the ruble looks more like its significant weakening.
Earlier Russia had a different exchange rate regime – the dual-currency corridor, which was canceled only in November 2014. This regime exists in a number of countries. And if you compare different developing countries, you can see that countries with a fixed exchange rate on average have higher economic growth. What is the problem then, why not fix the exchange rate? The fact is that countries that live with a fixed exchange rate react very strongly to international liquidity, to the changes in the attitude of international investors. With a floating exchange rate, the economy levels out external shocks on its own. For example, when export prices fall, the currency weakens, and imports also decrease at the same time.
Which regime is better – fixed or floating exchange rate – depends on the phase of economic development. Measured by the level of economic development Russia belongs to the top quarter of the world ranking, it is a relatively rich country. Russia will no longer be able to grow faster thanks to a fixed exchange rate. Therefore, it has made a choice in favor of a floating exchange rate.
And now, because of the freezing of reserves, the Central Bank would not be able to maintain a dual-currency corridor anyway. If it had such an ability, I think the regulator would try to keep the rate within RUB/USD 90-100. So far, practically the only player in the foreign exchange market are exporters, who are obliged to sell 80% of their foreign exchange earnings. Therefore, the state introduced capital controls in order to lock foreign currency within Russia.
Signs that international reserves are not protected from sudden financial attacks have been around for a long time. This was demonstrated by the cases of both Iran and Venezuela which could not even get its gold from the Bank of England, as well as other countries that had serious problems with access to their international reserves.
It seemed to everyone that this was unlikely to be the case for a large economy. But it turned out that size does not serve as protection. However, I think this is an unrealistic scenario for China. If the US acts so aggressively towards China's reserves, it will cause such a collapse in the financial markets that Russia’s case will fade. In addition, trade relations between China and the United States are very broad.
Meanwhile, I have heard (this is only a rumor, but a curious one) that many central banks – certainly not the ECB or the Fed – are worried and wondering what they should do, since the US dollar has become a financial weapon of mass destruction. No local currency can be safe now. I am not sure that this will give great benefits to China and the renminbi, because the transformation of a local currency into an international one is a slow process. China has been trying to make yuan an international currency for over 12 years, since the crisis of 2008-2009. But so far, the share of the renminbi in payments through the SWIFT system is about 2-3%. The US dollar and the euro account for about 40% each. And it will be like this for a very long time. Nevertheless, changes will almost certainly occur, perhaps countries will be turning more to monetary gold.
This is a mandate of the government and not the Central Bank. The government is responsible for budget policy, taxes, investment policy, it sets goals for technological development, etc. The Central Bank, in fact, does not directly control even the money supply.
The Fed has a dual mandate (almost no one else does) – it has the goals of monetary stability (inflation about 2%), and maximum employment (unemployment at about 4-6%). But the fact is that the Fed seeks to achieve both of these goals with the help of one tool – interest rates.
Numerous research papers show that an independent central bank that does not obey the politicians’ orders and is not directly connected with government agencies is much more effective in achieving financial and price stability. This does not mean that making the central bank independent would automatically make the economy better. But we see the examples of the Russian Central Bank, which has done a lot to protect the economy from the crisis, and the Central Bank of Turkey, where inflation reached 50% on an annual basis.
Gold is not a defensive asset; it is a low-yield and volatile asset. Rather, it is a way to diversify the portfolio. Historically, bonds have been the best asset to protect from inflation. But there is an important point: in recent years, we have seen an increase in inflation rates in many countries, including developed ones, with a weak reaction from central banks. When inflation is approaching a double-digit level, perhaps central banks should take decisive steps. So, generally there are no good answers to ways to hedge against inflation. Gold is volatile, cryptocurrencies are volatile, bonds do not fully compensate for inflation – neither American, nor European. That's why I have bad news: as always, investors lose if they have not prepared in advance.
