OREANDA-NEWS. Central Bank of Russia decision to keep interest rates on hold highlights the policy challenge facing the central bank as it shifts to inflation-targeting while Russia confronts the twin threats of weaker growth and possible capital flight, Fitch Ratings says.

The CBR held its main interest rate at 8.0%, after rises in March, April and July totalling 250bp. The first rise was in the same month that the EU and US began sanctions in response to Crimea's secession referendum.

Monetary tightening has demonstrated the Russian authorities' commitment to their policy framework, as has the limited fiscal stimulus, mostly achieved off balance sheet by allowing the National Wealth Fund to lend to infrastructure projects, and the decision not to modify the fiscal rule. Weak growth is already manifest, while net private sector capital outflows decreased in 2Q14 and capital flight is inherently hard to forecast.

Nevertheless, investor risk aversion towards Russia has put pressure on the rouble, which fell to a record low against the dollar after the EU said extended sanctions would take effect today. Meanwhile, reserves are down more than 8% this year, and inflation remains high - consumer prices rose 7.6% yoy in August, and the official end-2014 target of 5% is unlikely to be met.

The CBR said rate changes would take into account "economic development prospects" and that if inflation expectations remained high and threatened to exceed its medium-term target it may continue raising the key rate.

Inflation will probably remain above target as the CBR adopts a fully-fledged inflation-targeting regime, partly due to rouble depreciation and partly to the impact of counter-sanctions (the EBRD says the food import ban could increase overall Russian CPI inflation by up to 2pp). Comments by government officials indicate the risk of political interference in monetary policy is growing, and easing in response to prolonged slow growth would test the CBR's credibility.

But monetary tightening is an additional drag on growth. Fitch have cut our growth forecast for 2014 to 0.5%. The protracted nature of the Ukrainian crisis and the resulting economic uncertainty means an outright recession is possible, and there are downside risks to our forecasts.

Greater exchange rate flexibility has given Russia a more effective buffer against volatile oil prices and other external shocks. But the progressive flotation of the rouble could further increase inflationary pressures if depreciation continues, making higher policy rates necessary to meet inflation targets.

Pressures on growth and reserves are reflected in the Negative Outlook on Russia's 'BBB' rating, which Fitch affirmed on 25 July. Fitch forecast further falls in reserves, to USD400bn by end-2015, assuming no improvement in external borrowing conditions. This would be the lowest level since mid-2009 but still represents a large buffer.

Russia's strong balance sheet remains a key rating support, and government finances are a strength. Rouble depreciation coupled with higher-than-expected oil prices and production has improved fiscal performance in 2014, enabling the authorities to project a federal government surplus (consolidated general government debt, including the regions, will run a deficit).