How the Bank of Russia influences inflation

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The Bank of Russia uses the key rate in order to impact inflation. Through a chain of economic interdependencies, the key rate influences a wide range of economic processes which eventually impact the growth rate of consumer prices.

Thus, a change in the key rate almost instantly results in a similar adjustment of overnight interbank lending rates. An operational objective of monetary policy is to keep interbank lending rates close to the key rate. This operational objective is achieved through monetary policy instruments employed by the Bank of Russia to manage banking sector liquidity. The system of monetary policy instruments and the continuous process of management of banking liquidity are components of the operational procedure of monetary policy.

In turn, an alteration of overnight interbank rates causes longer-term changes in money market rates, which takes slightly more time and is determined not only by the actual reduction or rise in overnight rates, but also by market participants’ expectations regarding their future movements.

Banks may use interbank loans along with other financial instruments, namely bonds, loans, and deposits. Therefore, changes in interbank lending rates entail alterations in interest rates in other segments of the financial market. Movements of interbank lending rates are translated into bond yields most quickly. In turn, interest rates on interbank loans and bond yields impact interest rates on bank loans and deposits. Thus, all interest rates in the economy gradually adjust in response to a key rate change.

Movements of interest rates in various segments of the financial market influence the propensity of economic agents to borrow, invest, save or spend funds. When interest rates go down, it becomes easier to finance current expenses using borrowing, while saving becomes less attractive. Contrastingly, when interest rates rise, deposits gain attractiveness, whereas loans lose it. Changes in consumer, production and investment activity influence aggregate demand in the economy, which in turn impacts consumer price dynamics.

In addition, alterations in market interest rates caused by a change in the Bank of Russia key rate influence the attractiveness of investment in ruble-denominated assets as compared to financial instruments in foreign currencies. As a result, demand for Russian instruments alters, changing the ruble exchange rate, which, in turn, is an important factor in the formation of domestic prices.

Moreover, the key rate impacts borrowing and lending activity, and, consequently, inflation through changes in the value of assets (securities, real estate) which may be used to secure loans. At the same time, a rise in the value of bank assets provides more opportunities for banks to expand lending. However, today these mechanisms of influence of the key rate on Russia’s economy are relatively insignificant.

Inflation expectations are essential for monetary policy transmission to the economy. They complement other monetary policy transmission mechanisms in the economy and influence their functioning. After all, these are the individual inflation expectations that economic agents rely on when they make decisions on spending, saving and investment, as well as set interest rates, salaries and prices. The Bank of Russia influences economic agents’ expectations through its information policy.

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