The Russian Central Bank and the Economic Challenges of War

The Central Bank of Russia remains the main player in managing the country's war economy, but growing evidence suggests that monetary and regulatory policies cannot indefinitely protect the Russian economy from Ukrainian drone attacks, more severe international sanctions, or its own self-imposed weaknesses.

Rate cut despite inflation

On July 24, the Central Bank of Russia cut the key rate for the tenth consecutive time, bringing it from 14.25% to 14%, despite an increase in the inflation forecast by 1.5 points on the same day. With inflation threatening to reignite, the central bank will be very reluctant to cut rates further, despite severe stagnation and a contraction in GDP in the first quarter of this year.

Expanding deficit despite higher oil prices

Russia's fiscal deficit reached 5.8 billion rubles in April, double that of the same period in 2025 and already exceeding the 3.8 billion rubles deficit expected for the entire year. The main cause, in addition to the 16% increase in military spending, is the decline in energy revenues. The closure of the Strait of Hormuz has created some opportunities for Russia to sell its oil at higher prices, but these gains have been offset by lower export volumes.

Ukrainian strikes and Western sanctions

At the beginning of 2026, Ukrainian drone attacks took offline 30-45% of Russia's refining capacity, causing domestic fuel shortages and reducing maritime product loads. Western sanctions have strengthened, with the EU lowering the price cap on Russian oil and new measures against facilitators of the shadow fleet. Consequently, Russia's oil and gas revenues from January to June fell to 64% of the level two years ago.

Preferential loans and inflationary policies

The official annual inflation rate is only 6%, but households' inflation expectations remain at 13%. Labor shortages caused by Russian military conscription and significant battlefield losses are a major driver. Official unemployment is at a historic low of 2.1%, well below the pre-war natural rate around 5%. Sanctions also limit Russia's access to imported machinery, technologies, and intermediate goods.

The cheaper credit offered to sectors supporting the war effort keeps them solvent, but cannot quickly create more labor or machinery. The result is an inflationary subsidy policy that forces the Russian central bank to keep the key interest rate high for all other sectors while growth stalls.

War-linked loans and banking crisis

Since the start of the war, a State Defense Order signed by Russian President Vladimir Putin has allowed the Kremlin to instruct selected banks to extend to defense contractors "preferential financing on terms set by the Government." This has led to an increase in the volume of subsidized loans, as documented by financial expert Craig Kennedy in January 2025. Our calculations show that the policy has also dampened monetary transmission.

Between mid-2023 and October 2024, the Russian central bank raised rates from 7.5% to 21%, but the increase was not uniformly transmitted across sectors. In the seven months that followed, during which the key rate remained at 21%, retailers and wholesalers took out long-term loans at an average rate of 24.9%, while producers paid only 12.2%. A statistical analysis of the past three years shows that for every one percentage point increase in the key rate, long-term loan rates increased by approximately 1.13 points for wholesale and retail businesses, 1.23 points for mining companies, and 1.13 points for electricity producers. For producers, however, long-term borrowing costs increased by only 0.20 points. Notably, producers' short-term borrowing costs increased by only 0.20 points. Notably, producers' short-term borrowing costs increased by only 0.20 points. Notably, the short-term borrowing costs for producers increased by only 0.20 points. Notably, the producers' short-term borrowing costs increased by only 0.20 points.

The impact on small and medium-sized enterprises

Small and medium-sized enterprises (SMEs) are particularly vulnerable in this context. The reduction in lending to SMEs, which went from a 30% annual growth in 2024 to negative territory by June 2026, indicates a financing crisis for this crucial sector of the economy.

SMEs represent a significant part of the Russian economic fabric and are often engines of innovation and job creation. Their crisis could have a cascading effect on the entire economy, increasing the risk of unemployment and reducing the country's ability to recover.

The challenge of fiscal sustainability

The growing fiscal deficit represents another significant challenge. Although a 2% of GDP deficit might be manageable under normal circumstances, the lack of access to international capital markets limits the options of the Russian government.

The increase in VAT from 20% to 22% and the reduction in the threshold for companies obliged to pay it are temporary measures that may not be sufficient in the long term. The government may need to consider other forms of revenue or spending cuts to avoid a fiscal crisis.

Outlook for the future

The current situation suggests that the Central Bank of Russia may find itself in an increasingly difficult position. The need to maintain high interest rates to control inflation, while at the same time supporting war-related sectors, creates a conflict of objectives.

If Ukrainian drones continue to hit Russian energy infrastructure, the situation could worsen further. This could lead to a reassessment of current strategies and a possible change in the country's economic policies.

Geopolitical implications

Russia's economic difficulties could have broader implications for the geopolitical scene. A struggling economy could reduce the country's ability to sustain its geopolitical objectives, influencing power dynamics globally.

At the same time, international sanctions are playing a crucial role in shaping the Russian economy. The new U.S. sanctions law, which could reach President Donald Trump's desk by this fall, would add further pressure on Russian revenues.

Options for Russia

Faced with these challenges, Russia may need to explore new strategies to support its economy. This could include greater attention to economic diversification, the development of national technologies to reduce dependence on imports, and the search for new trading partners.

However, any change will require time and significant resources, and the road to economic recovery could be long and complex.

The Central Bank of Russia is facing a series of complex and interconnected challenges. Current policies are creating imbalances that could have long-term repercussions for the country's economy. The situation requires careful evaluation and possible recalibration of economic strategies to address current and future challenges.

As the war continues, the Russian economy will have to navigate these difficulties, with implications that go beyond national borders and influence the global geopolitical landscape.