Russia Has an Inflation Problem

A s Vladimir Putin continues to pursue his Ukraine invasion, the specter of high inflation is haunting Russia. This does not bode well for the country’s long-term economic outlook nor for its maintenance of social stability, particularly given its past experience with high inflation.

Russia is no stranger to socially destabilizing bouts of high inflation. Indeed, in the early 1990s, in the wake of the Soviet Union’s collapse, Russian inflation reached 2,330 percent. And in 1998, during Russia’s debt crisis, inflation spiked at 84 percent.

These past episodes of high inflation must make it of considerable concern to the Kremlin that the country’s inflation has now approximately doubled over the past year to its current level of 9 percent. Given the country’s history, it will not take much for citizens to lose confidence in the ruble and to seek ways to shelter their savings from inflation’s ravages. Flight from currency to goods as an inflation hedge will make it all the more difficult for the central bank to regain control of the problem.

One factor contributing to the recent uptick in Russian inflation has been the continuing impact of the West’s punishing sanctions, particularly on Russia’s financial sector and technology imports. Some of that impact has been blunted by a surge of imports from Europe to Central Asian countries, which then forward them to Russia. China, too, has filled quite a bit of the gap. According to CEPA, China’s exports to Russia, including its exports of dual-use components covered by Western export controls, have increased by 60 percent since February 2022. Sanctions have limited Russia’s access to international financial markets, which has depressed investment, although some of this too is offset by China.

Another factor fueling inflation has been the growing labor shortage as a result of the military’s need for manpower in the aftermath of the surge of emigration from Russia in the months following the invasion.

However, the main source of Russia’s current inflation problem would seem to be the sharp rise in military spending that has caused the economy to overheat. One measure of the pressure that military spending is putting on the economy is the fact that such spending has approximately tripled since 2021. It now accounts for around 28 percent of the country’s overall budget expenditures and amounts to some 7.5 percent of GDP. This is around twice the corresponding share of defense spending in the U.S. economy.

To its credit, the Russian Central Bank recognizes the danger of another inflationary spiral and has acted aggressively to regain inflation control. Since the start of this year, the central bank has hiked interest rates by more than ten percentage points from 7.5 percent to their current level of 18 percent. These hikes, which also reflect efforts to protect the ruble, are around twice as large as those the Federal Reserve has had to implement over the past two years to get U.S. inflation under control. With Mr. Putin giving every indication that Russia has no intention of ending its Ukraine war anytime soon, it would seem that interest rates will have to be kept high for a long time as an offset to bloated military spending.

All of this means that while Russia’s overall economy may have been kept afloat to date by increased spending on guns, there has been less room to spend money on butter. At the same time, the prolonged maintenance of high interest rates is bound to curb private-sector investment and risks plunging the nonmilitary economy into a recession as the central bank tries to slow inflation. That is the last thing that Russia needs at a time when Russia’s poor demographics are being reflected in a shrinking labor supply.

If there is one thing that must be keeping Putin awake at night it is the recollection of how a Russian military adventure in Afghanistan contributed to the collapse of the Soviet Union. It did so not least because of the economic hardship and the social unrest that it sparked. Mark Twain famously said that “history never repeats itself, but it does often rhyme.” Putin, for whom the USSR’s collapse was such a formative event, will be doing everything in his power to ensure that history doesn’t rhyme in Russia’s case.