Hawkish comments by Central Bank of Russia (CBR) governor Elvira Nabiullina have surprised markets and analysts, with the regulator stating it would not cut rates before 2019 following the Russian government’s decision to increase VAT.

Nabiullina’s comments followed the CBR decision to keep the key rate on hold and further hawkish comments made in the wake of fresh US sanctions earlier in 2018. CBR deputy governor Ksenia Yudaeva had previously provided guidance suggesting the CBR would ease rates to a “neutral range” of 6-7% this year.

The Central Bank is now expecting Russian inflation to accelerate more than previously forecast following the Russian government’s announcement that VAT rates will rise from 18% to 20%, according to the CBR report. The higher VAT is now predicted to flow through to prices, meaning inflation is likely to accelerate to 3.5-4% this year (cf. CBR target of 4%) and to 4-4.5% next year, with the CBR saying it estimates the planned tax changes will add about one percentage point to inflation.

The CBR has warned “High inflation is not the only repercussion of the tax reform”, adding that the move could also trigger a decline in business activity next year, with the government’s announcement potentially the biggest threat to inflation, in the shorter term and economic demand over a longer timeframe.

15 out 20 economists surveyed by Reuters did not expect a rate cut, but the tone and directness of Nabiullina’s press conference “came as shock” for the markets according to Kirill Tremasov of ”Locko-invest”. “One phrase has moved market expectations for year-end from 6.785% to 7.25% and OFZ have sold off sharply”, he said, before adding “The CBR could have been managed expectations more effectively, as the VAT increase was not a surprise and the CBR is part of the tax discussion”

“As a rule, central banks do not react to VAT changes if inflation is close to the target”, stated VTB Capital chief economist, Alexander Isakov. “For example, the Czech National Bank did not see a risk in a 4% VAT increase in 2012. The CBR probably acted proactively in anticipation of broader pressures in Emerging Markets.”

Alfa Bank economist Natalia Orlova noted that fresh US sanctions in April 2018 “came as a surprise for the overly optimistic regulator and now it is overly negative about the changes in budget policies”. “The decision to keep the rate at 7.25% at the moment is in line with the level of the geopolitical risks, in our view”, says Orlova. The CBR however notes in its report that  the sanctions are unlikely to significantly affect business activity. 70% of surveyed companies do not feel their impact and even see an improving business climate.

In March-May, inflation climbed to 2.4% from 2.2% in January-February and was contained by cheaper food, Orlova writes. Non-food price growth in May jumped from an annualised 2.7% to 3.5% due to surging gasoline prices and RUB volatility, and inflation expectations jumped to 8.6%, the highest level since the start of the year. The Central Bank is predicting inflation will accelerate in the third quarter this year, and that the announced fiscal measures will mostly take effect next year.

“It is possible that due to the increase in VAT, the population will buy non-food products for future use in the second half of the year and that may accelerate consumption.  However, demand is likely to be weak in the first half of 2019”, says Isakov. After that, the CBR can only hope that government measures to implement Putin’s “May Orders” will work and the GDP growth potential will rise above the current 2% ceiling.

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The CBR used to changed it rhetoric dramatically depending on the market environment. In 2016, for example, the CBR was cautious about any potential easing but eased aggressively afterwards. A rate cut is possible later this year.