SBERBANK OF RUSSIA

SBERBANK OF RUSSIA

CENTRE FOR MACROECONOMIC RESEARCH, SBERBANK

5 August 2010

What does the Bank of Russia target?

© Centre for Macroeconomic Research 2

The crisis has prompted the Russian Central Bank (CBR) to review its policies drastically. New frameworks to provide the banking sector with liquidity have been developed and field-tested, including a variety of standard and fairly non-standard anti-crisis instruments. Other changes are under way, too. Specifically, the Bank of Russia has enhanced the transparency of its monetary policy. Interest rate changes are now subject to a clear schedule and are accompanied by explanations and comments. The exchange rate has become more volatile (at least on the face of it); the currency intervention system has changed. In this context, the CBR continues to reiterate in its key statements an intention to adopt inflation targeting. Accordingly, the changes mentioned above may be treated as steps in that direction.

Has the Bank of Russia really changed its key objective during the crisis towards inflation targeting? In this paper, we will address this question by estimating Central Bank’s monetary policy by the so-called forward-looking Taylor rule. The Taylor rule argues that a central bank modifies the value of its instrument in view of its expectations of future values of the parameters it is targeting. Here we pursue a fairly flexible approach, by using two potential instruments of monetary policy (repo rate and monetary base) and three types of independent variables, which may affect the policy of the CBR (inflation, output and exchange rate). We take the repo rate for the interest rate, because the CBR provides liquidity to the banking sector through this particular tool. Monetary base may be affected both by currency market interventions and by government related payments (from or to the Reserve Fund or National Welfare Fund). As far as independent variables are concerned, it is evident that the Bank of Russia takes account of not only inflation, but also of exchange rate and GDP growth.

Our results demonstrate that the CBR’s policy did change during the crisis. The role of the exchange rate as a policy factor diminished, the role of inflation and, particularly output, increased. For these reasons it would be premature to argue that there was a transition to inflation targeting. Rather, the CBR started making attempts to affect output through the credits instead of the currency policy transition mechanism previously used, in a move to stall appreciation of the currency.

Estimates of the CBR’s targeting function may be used not only for analytical purposes, but also in forecasting its future policies. Specifically, they help to understand which interest policy the Central Bank of Russia will be carrying out over the next several months. Our calculations show that the interest rate, i.e. the repo rate, is close to what may be calculated from the estimated rule. This notwithstanding, there are still opportunities for a minor decrease in summer. On the other hand, we forecast that by the end of the year, as inflation grows, the appropriate conditions will be in place for the rates to be raised. However, given that this increase will not be a dramatic one, the Bank of Russia may decide to postpone this decision in the interests of GDP growth stimulation.

Ksenia Yudaeva Director, Centre for Macroeconomic Research, Sberbank

Nadezhda Ivanova Head of Forecasting, Centre for Macroeconomic Research, Sberbank

Marina Kamenskikh Senior Expert, Centre for Macroeconomic Research, Sberbank


I. Bank of Russia targets In accordance with uniform monetary policy guidelines, the Bank of Russia pursues anti-inflation policies to support growth of the economy with regard to key macroeconomic indicator dynamics. It also controls the exchange rate, smoothing its fluctuations relative to the currency basket. It follows therefore that the CBR is continually making choice of the existing key priorities, and it is not always clear which aim it is pursuing at the moment. As the economy recovers, it is of paramount importance to deliver the appropriate macroeconomic policy. If the CBR’s policy is too tough, it may slow down growth; if it is too easy, it may result in overheating.

In this paper we try to identify what influences the CBR policy; which macroeconomic parameters are the most important, and to what extent. For this purpose, we estimate its monetary policy using the so-called forward-looking Taylor rule, which argues that the Central Bank changes the value of its instrument based on its expectations of the target variables, and that the Central Bank may shape such expectations using the available data. Following the classical principle of monetary policy, the CBR sets the interest rate or monetary base value in response to the expected movements in inflation or output, in order to regulate deviation of these parameters from target values. In addition, there is a modification of the Taylor rule for open economies, in which the exchange rate is introduced as an additional target variable. This modification is most likely relevant for Russia, given the role played by the foreign sector in its economy and the attention given by the CBR to the exchange rate. Finally, it should be mentioned that the CBR avoids any sharp turns in its policy and modifies the values of its instruments, e.g. the interest rate, gradually.

Multiple studies show that the policies of central banks in different countries1, including Russia2, may be described by one or another version of the Taylor rule. As regards the choice of the monetary policy ‘instrument’ (the variable controlled by the CBR to influence the economy), there are several options. The interest rate featuring in the classical Taylor rule is the most relevant instrument for the developed countries. Monetary aggregates may also be treated as monetary policy instruments3, which makes sense in estimating the Taylor rule in the case of Russia, where the CBR influence on the interest rate has traditionally been limited.

We attempt to estimate to what extent the CBR’s policy over the long period of time (from the beginning of 2003 to this moment, including the 2008-09 crisis) could be formalised within the framework of the forward-looking Taylor rule, which assumes that the CBR changes it’s instrument in response on the expected changes in fundamental economic indicators. By an estimation of the Taylor rule for the CBR over a long period of time, we are able to understand to which extent the recent moves of the CBR comply with that rule. We also offer a forecast of the most likely changes in

1 Clarida, R., Gali, J., Gertler, M. L. (1997): “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory”, NBER Working Papers № 6254. Clarida, R., Gertler, M. L. (1996): “How the Bundesbank Conducts Monetary Policy”. NBER Working Paper № 5581. 2 Drobyshevsky S., Kozlovskaya A. (2002): Domestic Aspects of Russia’s Monetary Policy. Vdovichenko А, Voronina V. (2004): Monetary Policy Rules of the Russian Central Bank. Drobyshevsky S., Trunin P., Kamenskikh M.: An Analysis of the Monetary Policy Rules of the Russian Central Bank in 1999–2007. 3 McCallum, B. T. (1982): Money stock control with Reserve and Interest Rate Instruments under Rational Expectations. Bernake, B. S., Mihov, I. (1998): The Liquidity Effect and Long-run Neutrality.


Central Bank’s policies for the second half of 2010 and for 2011, under different scenarios of economic development.

II. Monetary policy instruments of the Central Bank We assume that the CBR delivers its policy by affecting the value of the ‘instrument’. The ‘instrument’ is a monetary policy indicator with its value on the one hand, largely controllable by the Bank of Russia through its own operations, such as interest rates and provisioning requirements changes, open market transactions, currency interventions, direct qualitative restrictions and bond issuance in its own name; on the other hand, the value of the ‘instrument’ should affect key macroeconomic indicators through transmission mechanisms of the monetary policy. We consider the auction-based direct repo rate and the monetary base growth rate as the Central Bank’s instruments.

We chose the monetary base as a monetary aggregate most affected by Central Bank’s actions. Interventions on the currency market and government related payments (to or from the Reserve Fund or National Welfare Fund) influence the level of monetary base.

Several rates adjusted by the CBR from time to time (such as repo, inter-bank market and CBR deposit rates) may be treated as a proxy for the CBR interest rate. There may be doubts, however, as to whether inter-bank market rate may be regarded as a CBR instrument. It is well known that inter-bank lending mechanism is opaque and that the market is well segmented. Therefore, Central bank's open market operations have limited effect on interbank market, which is confirmed by high volatility of the inter-bank rate. A regression analysis of the Taylor rule (see equation 1) demonstrates that the inter-bank rate does not react in a statistically significant manner to deviations from target values of expected macroeconomic indicators (inflation, output and exchange rate).

The regression analysis also shows that the CBR deposit rate is not sufficiently sensitive to the expected changes in fundamental indicators. Consequently, this policy instrument couldn’t be described by Taylor rule. This result comes as largely predictable, because CBR deposit operations set the lower limit for interest rates in the economy and act as a mechanism that absorbs free bank liquidity.

On the other hand, direct repo operations are a standard mechanism through which the Russian CBR provides large amounts of liquidity to the banking sector (daily transactions averaging RUB 31,482 billion). It played a very significant role during the crisis in supporting the banking sector. Total transactions via this instrument in 2009 amounted to RUB 24,986 billion against RUB 7,730 billion in 2007.

In our calculations, we use the average rate of direct repo auctions. We disregard the fixed rate direct repo sessions owing to low transaction volumes (cf. RUB 206 million and RUB 119 trillion on direct repo auctions in June 2010). The results of the regression analysis presented below demonstrate that repo rate movements can actually be described by the forward-looking Taylor rule.


Fig. 1. Interest rate dynamics

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Refinancing rateREPO rateInterbank rate

III. Taylor rule estimation

The Taylor rule may be applied to the interest rate in the following manner (see Appendix for details):

1 1 e e et tr r r y y er er * * * *( ) , (1)

where r* is the CBR nominal interest target of ye, πe, ere are the expected output, inflation and real exchange rate

у*, π*, er* are the target output, inflation and exchange rate of the Central Bank.

Similarly, the Taylor rule for the monetary base used as a CBR policy instrument looks as follows:

1 1 e e et tm m m y y er er * * * *( ) , (2)

where tm means the actual monetary base growth rate, and *m means the target value of monetary base growth rate.

The Taylor rule estimates for repo interest rate and monetary base (equations (1), (2)), provided in Table 1, were obtained using the Generalised Method of Moments (see Appendix).

We estimate the Taylor rule for interest rate and monetary base for the period from January 2003 to April 2010. In order to understand whether or not the Central Bank’s policy changed after the crisis, we also estimate the model for the pre-crisis period, from January 2003 to April 2008. Calculations show that there was a shift in Central Bank’s priorities: after the crisis, CBR started to focus more on supporting output and controlling inflation, giving less attention to the exchange rate stability. Also, changes in Central Bank’s interest rate after the crisis became more inertial, with less sharp fluctuations.


Table 1. Taylor rule estimation results

Parameter

Entire period:

Jan. 2003 Apr. 2010

Pre-crisis period:

Jan. 2003 Apr. 2008

Entire period:

Jan. 2003 Apr. 2010

Pre-crisis period:

Jan. 2003 Apr. 2008

Smoothing ρ 0,671 0,642 0,19 0,24

Inflation β 1,109 1,053 -3,57 -3,83

Output γ 4,204 0,542 -0,448 -9,029

Real exchange rate φ -0,508 -0,698 0,744 1,083

Table 1 supports these conclusions. In the interest rate equation (estimated across the entire period, including the crisis), all parameter s are statistically significant. It follows that throughout the period in review the Central Bank, while setting the interest rates, was taking account of the changes in expected inflation, output and real exchange rate. Furthermore, the interest rate policy is fairly inertial, which is demonstrated by the parameter before the first lag (ρ= 0,667). The CBR was aiming to smooth the interest rate fluctuations and to avoid excess volatility. In the Taylor rule, estimated for the pre-crisis period, parameter ρ is slightly lower (0,642).

An analysis of Taylor rule parameters, estimated for two periods, shows that supporting output unrelated to real exchange rate changes became a key priority for the CBR immediately after the crisis. In the pre-crisis model the interest rate does not react significantly to deviations from the output target value; the output for the entire period, however, turns out to be not only statistically significant, but also comes in the Taylor rule with the highest absolute parameter value (4,2).

The Central Bank’s reaction to inflationary fluctuations changed after the crisis: the parameter for inflation for the entire period was higher than in the model exclusively for the pre-crisis period. Furthermore, on the basis of the Taylor rule estimate for the entire period, the Bank’s inflation policy may be described as tight. The parameter β value was > 1, which means that the Central Bank’s intention was to change both nominal and real interest rates (see Appendix), thereby affecting demand and inflation.

On the other hand, before the crisis, the CBR was focusing more on real exchange rate movements: in the equation estimated on pre-crisis level, the absolute value of the parameter for the real exchange rate (-0,698) is higher than in the equation for the entire period (-0,508). These results conform to the statements of the CBR regarding gradual transition to the so-called ‘modified inflation targeting’, a policy that has proved to be efficient for the developing countries heavily dependent on trade revenue flows. The ‘modified inflation targeting’ policy assumes that alongside the key priority (which is maintaining sustainable inflation), the monetary authorities also react to exchange rate


fluctuations, bringing down the volatility of economic indicators dependent on real exchange rate fluctuations, in view of the contribution of exchange rate fluctuations to inflation.

An estimation of monetary base equations has shown the CBR did not intend to support output trough controlling monetary base growth either before or after the crisis (In both the equations output parameter s appeared to be insignificant). Inflation was the key factor affecting the moves of the CBR in controlling the monetary base: the appropriate parameter in the Taylor rule equation, estimated for the entire period, is minus 3,57 (against minus 3,83 for the period before the crisis).

Similar to the interest rate model, the Central Bank’s focus on the exchange rate weakened after the crisis, the appropriate parameter decreased from 1.083 (in the pre-crisis period equation) to 0.744 (in the entire period equation). It’s worth mentioning that when controlling monetary base the CBR tries to affect exchange rate in the current rather than future period (unlike in the model with interest rate). Also, the rate of monetary base growth appears to be more volatile as compared to the interest rate (even if we take into account seasonal factors): the Taylor rule for monetary base yields a lower smoothing parameter .

Furthermore, in order to determine the impact of the crisis on monetary policy indicators, we use a logical variable for the most acute phase of the crisis when estimating the Taylor rule for the entire period (November 2008 – September 2009). According to the results, the interest rate during the crisis was about 1.3 bp higher than it would be if we take into account only fundamental factors (on changes in output, inflation and exchange rate); whereas the monetary base monthly growth was 2.8 bp lower than might be explained by fundamental factors.

IV. Forecasts On the basis of model estimates, we can forecast the rate, assuming that the CBR will pursue its policy, following the estimated Taylor rule and guided by the expected values of fundamental indicators. We consider several scenarios for the Russian economy until the end of 2010 and for 2011, based on the forecasts of the Ministry of Economic Development (MED) and Sberbank Centre for Macroeconomic Research (CMR) (see “Russian Economy Development Forecast for 2010-2011 and 2012-2013”).

MED offers several macroeconomic scenarios for Russia. In the pessimistic scenario (1а), GDP growth in 2010 is 3.1%; in 2011, 2.6%. In the optimistic (1с), the Russian economy grows by 4.5% in 2010 and by 3.7% in 2011. We also provide analysis for three CMR forecast versions: base-line, pessimistic, and optimistic. In the base-line version, GDP growth in 2010 and 2011 is 4.4% and 3.6% respectively; inflation, 6.8% and 7.1%, whereas the Rouble appreciates in both nominal and real terms. Table 2 shows the key parameters for the scenarios we are using.

We calculated GDP’s deviation from the long-term trend in different scenarios. To determine the target inflation rate we use the inflation values stated by the CBR as qualitative benchmarks of monetary policy (2010, 9%; 2011, 7%; 2012, 5%.). According to CBR statements, zero fluctuation in the real exchange rate (er*=0) may be regarded as the objective of its policy in these years.


We got the interest rate the CBR would set according to the estimated rule in all scenarios. The results are summarized in Table 3.

According to all scenarios September-October 2010 should be taken for the critical moment in the interest rate dynamics with the CBR starting to raise the interest rate expecting further growth of the economy and rising inflationary expectations.


Table 2. Russian economy development forecasts

Scenario Year Real GDP

growth rate, %

Inflation (CPI), %

$/EUR rate

Average annual bi-currency

basket, RUB

Rouble appreciation in

real terms

2010 4,4 6,8 1,29 34,2 12,7

2011 3,6 7,1 1,29 32,6 9,9 CMR

base-line

2012 3,9 7,4 1,32 31,9 8,6

2010 3,0 7,5 1,22 35,0 9,3

2011 0,9 6,9 1,00 35,6 1,1 CMR

pessimistic

2012 1,8 8,9 1,10 39,1 1,7

2010 5,2 6,6 1,31 33,8 15,0

2011 5,5 7,1 1,32 30,7 14,0 CMR

optimistic

2012 4,7 6,9 1,35 28,7 10,8

2010 3,1 6,5 1,30 34,1 12,5

2011 2,6 6,0 1,30 33,3 6,1 MED 1а

2012 2,4 5,5 1,35 33,7 0,2

2010 4,5 6,5 1,30 33,8 13,6

2011 3,7 6,0 1,30 32,6 10,0 MED 1с

2012 3,9 5,5 1,35 30,8 -1,1

In CMR base-line scenario, the interest rate in December 2010 is 5.75 %: the average repo rate for 2010, 5.68%; the average for June 2001, 6.04%. In June 2010 the average repo rate was 5.10%.

A comparison of interest rate movements in three CMR scenarios (see Fig. 2) shows that in CMR pessimistic the rates are higher, because (despite slow growth and low inflation) strong depreciation of the currency (which ‘pulls’ the rate down) makes the CBR raise the rates, and that effect proves to be dominating.


Fig. 2. Direct auction-based repo forecast rates

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In MED pessimistic (1a), the CBR rate reaches 5.94% in December 2010, and 6.22% in June 2011. MED optimistic (1с) also implies rate growth in the near future, but weaker than in pessimistic. In optimistic, the positive effect on the rate caused by fast growth is lower than the impact of a stronger Rouble, which makes the CBR keep the rates low.

Thus, the fact that the CBR continues to focus on the exchange rate leads to somewhat paradoxical conclusions if the rate movements are compared in different scenarios from the point of view of interpretation of the classical Taylor rule (which includes only inflation and output). The recent events demonstrate that such a development is possible: thus, at the peak of 2008 – early 2009, when monetary authorities in most countries were bringing interest rates down, the CBR was trying to use high interest rates in a move to protect the currency from devaluation.


Table 3. Interest rate forecast values

Repo rate, %

Entire period:

Jan. 2003 Apr. 2010

Pre-crisis period:

Jan. 2003 Apr. 2008

MED, pessimistic (1a)

December 2010 5,94 5,80

2010 average 5,75 5,70

June 2011 6,22 5,90

MED, optimistic (1c)

December 2010 5,88 5,61

2010 average 5,74 5,64

June 2011 6,16 5,69

CMR

December 2010 5,91 5,51

2010 average 5,75 5,57

June 2011 6,15 5,58

CMR pessimistic

December 2010 6,12 6,07

2010 average 5,86 5,84

June 2011 6,34 6,19

CMR optimistic

December 2010 5,81 5,43

2010 average 5,71 5,57

June 2011 6,13 5,49


Appendix1

Taylor rule is the rule assumes that the Central bank sets nominal target interest rate rt

* in response to divergences of

actual variables the bank is concerned about from their target inflation values:

* * * * *e e etr r y y er er

where r* is the equilibrium nominal interest rate, targeted by the central bank; ye, πe, ere are the expected output, inflation, and exchange rate; and у*, π*, er* are the target output, inflation and exchange rate. Given the equilibrium between the expected and the target indicators, interest rate rt

*

is equal to r*.

The equation for the real interest rate looks as follows:

* * * *1e e e et trr r rr y y er er ,

where *rr is the equilibrium target real interest, * * *rr r .

If 1 0 , then the increase in the nominal interest rate as a response to anticipated growth in inflation results in a higher real rate and, later, in a shrinking of demand and inflation. When β>1, this is an indicator of what is called active monetary policy.

It’s also assumed that the Central bank avoids sharp fluctuations in the interest rate and tends to smooth them:

1 1t t tr r r *( )

As a result, the Taylor rule may be presented as follows:

1 1 * * * *( ) e e et tr r r y y er er (1)

where interest rate (r), is assumed to be a central bank policy instrument (monetary aggregate could be treated as an instrument too).

We assume ,( | )et t k ta E a to be rational expectations of the variable a (inflation, output, and

exchange rate) after k periods, which are based on all available information Ωt at the moment t. We assume that monetary policy affects a after k periods; accordingly, the Central bank makes k periods ahead forecast for variable a. The expected variables’ values are computed using instrumental variables in a Generalised Method of Moments framework. The instrumental variables describe the set of available information at the moment t.

It is assumed that the CBR will use all available data to predict the future values of indicators it is concerned about.


Thus, the final regression equation could be written as follows:

1 1 21 0t t t t k t t t k t t t k t tE r L r r E E y y E x x z

* * * *, , ,( ) ( ) ( | ) ( | ) ( | ) (2)

Empirical estimation The unit root test showed the stationarity on the variables, used in the model. The optimal set instruments were selected by the Hansen’s J-statistics and LM test for underidentification. Also, we checked residuals for heteroscedasticity in the equations.

We take into account that given higher risks on global markets, monetary policy during the crisis period could be tougher. For this reason, we use dummy variable cris for the most acute phase of the crisis (November 2008 – September 2009):

cris=1, if November 2008 < t < September 2010 cris=0, otherwise.

We also use interaction regressors by taking the products of all dummy variable cris and explanatory variables Y=ytk-y*, PI=πtk-π*, ER=er-er*. So, we estimate the following equation:

*t t -1 t t t,k t,k1 t,k2 t t,k t t,k1 t t,k2t t t tE r - ρr - cris - 1 - ρ α +E βPI + γY +φER + βPI ×cris + γY ×cris +φER ×cris | Ω z = 0 (3)

The equation for monetary base looks similar, because of great importance of seasonality for money aggregates seasonal dummies are included too.

We consider models with forecast periods (k) from one to six lags. The final results of our estimates are shown in Table А1.

In the Taylor equation estimated on the whole period (January 2003 to April 2010) parameter s before variables t,k tPI ×cris , t,k1 tY ×cris , t,k2 t tER ×cris appeared to be insignificant in both the interest and

monetary aggregate model. So, we excluded this variables from the final model. At the same time, variable tcris appeared to be significant both for the interest rate equation (the parameter value is 1,323, significant at 1%) and the monetary base equation (the parameter value is -2,929, at 5%). This proves stricter CBR policy during the crisis.

Variables used In our estimations we use monthly data for the period from January 2003 to May 2010.

As the dependent variable we use monetary base growth rate (source: CBR) and weighted repo rate (source: CBR, author’s calculations).


The real GDP was calculated as nominal GDP shown by the Finance Ministry in monthly reports on federal budget compliance, discounted by CPI. The output target was estimated as the deviation of real GDP logarithm from the long-term trend, computed by the Hodrick-Prescott filter.


Table А1

Instrument Repo Monetary base growth rate

Entire period: Jan.

2003 - Apr. 2010

Pre-crisis period: Jan. 2003 Apr. 2008

Entire period:

Jan. 2003 - Apr. 2010

Pre-crisis period: Jan. 2003 Apr. 2008

Repo rate (-1) 0,671***

0,00

0,642***

0,00

Monetary base growth (-1) 0,194**

0,02

0,244***

0,01

Inflation deviation from target value (+4)

0,365** 0,02

0,377* 0,06

-2,878** 0,01

-2,898** 0,02

Output deviation from trend (+6)

1,383** 0,03

0,194 0,79

Output deviation from trend (+4)

-0,361 0,94

-6,826 0,28

Real exchange rate growth deviation from target (+4)

-0,167*** 0,01

-0,250* 0,07

Real exchange rate growth deviation from target

0,600* 0,07

0,819** 0,02

January dummy variable -16,381***

0,00 -19,147***

0,00

December dummy variable 15,835***

0,00 14,154***

0,00

Constant 2,050***

0,00 2,231***

0,00 1,894***

0,00 1,726***

0,01

Crisis 1,323***

0,00

-2,840** 0,04

J-statistics 0,78 0,339 0,638 0,352

Over identification 0,065 0,086 0,004 0,021

Heteroskedasticity 0,370 0,289 0,358 0,285


Number of observations 80 58 80 69

Parameter significance level: *** 0,01; ** 0,05; * 0,10.

Inflation is calculated as the monthly growth rate of Consumer Price Index (source: Rosstat). The explanatory variable in the Taylor equation, is the difference between actual CPI growth rate and official inflation target declared by the CBR.

We compute real exchange rate growth deviation from target as the difference between the real effective Rouble exchange rate growth (source: IMF) and officially declared CBR target exchange rate growth.

As instrumental variables, we use lagged values of all variables, included in the equation, seasonal dummies, as well as lagged and current values of Brent price growth rate (source: EIA), M2 growth rate (source: Russian Central Bank), budget deficit to GDP (source: Rosstat) and capital inflow to GDP (source: Russian Central Bank).


Standard disclaimer to be attached to all analytical products.

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