Wednesday, December 17, 2014

Letter from Diogenes on Interest Rate and Russian Central Bank

by "Diogenes"

Preamble: First of all, when I heard of Central Bank decision to increase the rate, I have to admit that number looks suspiciously familiar to me. Yes, I knew Central Bankers manual. If you wish I can send you this

That number 17% was used by my professor of macroeconomics who was lectured Central Bank staff consequently. It was in all American books on Macroeconomics, from 80s - old recipe how to fight inflation.

Paul Volker, then Governor of FED has to deal with double digit inflation from price shock, subsequent increase of liquidity and inflation expectations by the market - hike of crude oil prices caused by OPEC.

Paul Volker was appointed chairman of the board of governors for the Federal Reserve System in August 1979. The Federal Reserve board led by Volcker is widely credited with ending the United States' stagflation crisis of the 1970s. Inflation, which peaked at 13.5% in 1981, was lowered to 3.2% by 1983. Volker raised the Fed funds rate from 11 to 20% . Professor used exactly 17% interest rate in his lecture. Mr. Volker killed then double digit inflation (caused by plenty of liquidity) to 3% by 1981. Cost of that exercise was deepest and longest recession of US economy since WWII.

The Ladies that run Central Bank of Russia now are belong to macroeconomic sect dogmatic and they won't be able to change their mind quickly.

Consequences of the decision (IMHO):

1) IT WON"T STOP devaluation: Currency speculators wont be scared - they will continue to play against ruble because their collective efforts can push and depreciate ruble more then 17% in a day or two. Why to deposit ruble for a YEAR and earn 17% if one can make same return in a week?

2) Rate of 17% will be impossible burden on real sector industries and banks (except largest - with access to CBR refinancing) even so only very profitable business has margin big enough to afford loan at 20 plus%. Note: In 90s casino's were good borrowers of the Banks

3) Russian stock market will tumble. Stocks evaluation use cost of capital, so called WACC - weighted cost of capital, in denominator- higher rate is - lower stock price.

4) This is not a cure, but poison medicine. Rate increase is a wrong prescription for this situation. It will led Russian economy to deep and prolonged recession and they know it- this is written in their manual.

PS Central Bank will try to increase rate few more times to the range of 20% ( or 30%?) to no avail for exchange rate, unless those ladies are fired.

best regards