Russia's central bank decided to lift its key rate unexpectedly on Friday as geopolitical tensions increased risks of inflation amid rising threats to growth.
The Board of Directors of Bank of Russia raised the key rate by 50 basis points to 8 percent. The bank was widely expected to leave rates unchanged.
This was the third increase in interest rates this year. The rate has been hiked by a cumulative 250 basis points since February.
Policymakers noted that the slowdown in inflation was slower than expected in July. Moreover, inflation risks increased due to the aggravation of geopolitical tension and its potential impact on the currency exchange rate.
Consequently, the bank sees threats of inflation exceeding the target in the coming years. The bank also said it will continue to raise the key rate if high inflation persists.
In the absence of negative shocks, the bank estimates inflation to decline in the second half of 2014. The rate hike decision will set conditions for inflation to reach 6-6.5 percent by the end of 2014 and to the target level of 4 percent in the medium term, it said.
It is pretty clear that this is a pre-emptive move to limit capital outflows ahead of possible new sanctions by the US and Europe, said Neil Shearing, chief emerging markets economist at Capital Economics.
"How far rates might have to rise in this scenario is difficult to say, but we wouldn't rule out the policy rate going to 10 percent or more," the economist said. He added that today's move is yet another example of how Russia's economy is more vulnerable to sanctions than most still seem to believe.
New sanctions imposed on Russia by the European Union and the US after the downing of Malaysia Airlines flight MH17 worsened the conflict with Ukraine and the political instability in the region.
According to the Bank of Russia estimates, GDP growth was close to zero in the second quarter. External political uncertainty has a negative impact on economic activity, the bank said. Investment demand remains weak amid low business confidence and consumer activity is cooling.
Economic slack in most trading partners also drag growth in Russia. At the same time, persistently high oil prices support domestic economy, the central bank said.
Rating agencies Moody's Investors Service and Fitch Ratings are set to review the sovereign ratings of Russia, later today. Currently, Russia has 'Baa' rating from Moody's and 'BBB' rating from Fitch.
In April, Standard & Poor's downgraded the Russia's rating to BBB-, the lowest investment grade.
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