Russia's central bank raised its key interest rate by 50 basis points to 8.0 percent to reduce inflation and pledged it would raise rates further if inflation expectations remain heightened and inflation threatens to exceed its target in coming years.
The Bank of Russia, which adopted an inflation-targeting regime on Feb. 1, has now raised its rate three times this year by a total of 250 basis points following rate rises in March and April.
Russia's headline inflation rate accelerated further in June to 7.8 percent, the fifth month in a row of rising prices, with inflationary risks continuing to build due to "the aggrevation of geopolitical tension and its potential impact on the ruble exchange rates dynamics, as well as potential changes in tax and tariff policy," the central bank said, adding:
"The build-up of these risks will lead to inflation expectations remaining heightened and creates threats of inflation exceeding the target in the coming years. The adopted decision is aimed at slowing the consumer price growth to the 4.0% target level in the medium term. If high inflation risks persist, the Bank of Russia will continue raising the key rate."
Economists had expected the central bank to maintain its rates today.
However, at its meeting in June when it maintained rates, the bank warned it would raise rates if its inflation target was threatened by a further decline in the ruble's exchange rate, higher food prices, administered prices or inflation expectations.
The central bank targets inflation of 5.0 percent this year, 4.5 percent in 2015 and 4.0 percent in 2016. It averaged 6.8 percent in 2013.
In addition to its key rate, the Bank of Russia also raised other main rates, including the 1-day repo rate that was increased to 9.0 percent from 8.50 percent, effective July 28, along with the 3-month liquidity provision rate that was raised to 8.25 percent from 7.75 percent. Liquidity absorption rates were also raised, with the 1-day rate up to 7.0 percent from 6.50 percent.
After tumbling in the first few months in response to the growing tensions with Ukraine and a general shift of global capital away from emerging markets, the ruble started to gain strength after the central bank's 150 basis point rate rise on March 3 in response to a plunge in Russia's stock market and a sharp fall in the ruble.
Another 50 point rate hike in April supported the ruble further, but since late June the ruble has again been depreciating and was trading around 35 to the U.S. dollar today, down from 33.7 on June 29. Since the beginning of the year, the ruble has lost 6 percent.
In the week through July 18, Russia's international reserves fell $4.2 billion to $472.5 billion.
"The main reason for inflation acceleration was the effect of the observed ruble depreciation on prices of a wide range of goods and services," the central bank said about June inflation.
Although inflation slowed to an estimated 7.5 percent as of July 21 from June's 7.8 percent due to a decreasing impact of the January-March decline in the ruble along with lower food prices from the new harvest, the central bank said the deceleration in inflation was slower than expected and inflation expectations have remained elevated.
Assuming there are no further negative shocks, the central bank expects inflation to decline in the second half of the year to between 6.0 and 6.5 percent by the end of 2014 and then fall further toward the bank's 4.0 percent target in the medium term.
"At the same time, there is an increased probability of negative trends which may result in inflation acceleration," the central bank said, adding:
"These shocks include aggregation of geopolitical tension, adjustments in the monetary policy of foreign central banks and the potential impact of those factors on national currency exchange rate dynamics, tax and tariff policy changes under discussion."
Russia's economy contracted in the first quarter of this year with Gross Domestic Product shrinking by 0.3 percent from the previous quarter but the central bank said it recovered moderately in the second quarter with GDP growth of close to zero.
The government has forecast a 0.5 percent economic expansion this year after 1.3 percent in 2013, with international sanctions due to Russia's conflict with Ukraine and the tighter monetary conditions impacting lending growth and economic activity, including consumer demand.
Low economic growth is mainly due to structural factors, with sluggish growth in labor productivity and a shortage of labour affecting growth in the long term, the bank said.
"Along with structural factors, external political uncertainty has a negative impact on economic activity. Investment demand remains weak amid low business confidence, limited access to long-term financing both international and domestic markets, and declining profits in the real sector," the bank said.