MOSCOW Russia unexpectedly raised interest rates for the second time in two months on Friday and suffered its first credit rating cut in five years, highlighting the impact of the Ukraine crisis on the teetering economy.
The central bank raised its key rate by 50 basis points to 7.5 percent to prevent a weakening ruble fuelling inflation.
Hours earlier, Standard & Poor's cut Russia's credit rating to just one notch above junk status and warned more could follow if tighter sanctions were imposed and capital flight, which saw $64 billion hemorrhage from the country in the first quarter, was not stemmed.
"The central bank is indirectly trying to defend the ruble against the backdrop of credit ratings downgrade and the West's tough rhetoric about the possibility of new sanctions against Russia," said Dmitry Polevoy, an analyst at ING Bank in Moscow.
Both moves highlighted the impact on Russia's weakening economy of the tense standoff with the West over Ukraine.
President Vladimir Putin acknowledged this week that sanctions imposed in response to Russia's annexation of Ukraine's Crimea region last month are already hurting the Russian economy, thought not critically.
The West has threatened tougher sanctions, with U.S. Secretary of State John Kerry warning Russia on Thursday that it would be making "an expensive mistake" if it did not change course over the Ukraine crisis.
Friday's hike came less than two months after the central bank raised rate by an emergency 150 bps in early March. It said the move was due to accelerating inflation due to the weakening ruble and the a rise in inflation expectations.
It said it did not intend to lower rates in the coming months.
S&P kept its outlook negative and stressed the impact of capital flight. Foreign investors withdraw $63.7 billion from Russia in the first three months of the year.
"The tense geopolitical situation between Russia and Ukraine could see additional significant outflows of both foreign and domestic capital from the Russian economy and hence further undermine already weakening growth prospects," it said.
The World Bank has estimated capital flight may reach a record $150 billion this year.
Economy Minister Alexei Ulyukayev dismissed the downgrade, saying, "Partially, it is kind of a politically motivated decision."
But analysts said other rating agencies were likely to follow suit, and Russia's already battered financial markets fell further on Friday.
The ruble briefly firmed after the rate hike but gave up all its gains and was last down 0.7 percent on the day at 36.02 to the dollar. The MICEX stock index fell 1 percent.
"Russia is going backwards as reflected by developments in relations with Ukraine and the West," said Timothy Ash, analyst at Standard Bank.
"(This is)... bad for growth (long term and short term), bad for investment, bad for capital flows, and bad for broader political, economic reform and institutional reform.
The central bank said the probability of inflation exceeding its 2014 target of 5 percent had increased significantly and the decision to raise rates would ensure that inflation stays now below 6 percent this year.
"The central bank is now skewed towards excessively tight monetary policies to earn market trust on its path to inflation targeting," VTB Capital analyst Daria Isakova said in a note.
But analysts at BNP Paribas said, however, that the tight policy may not be enough to stop the ruble, which has lost nearly 9 percent against the dollar this year, falling further.
"The relatively minor increase in rates will do little to prevent further pressure on currency if the conflict in Ukraine continues escalating," the analysts said in a note.
Russia's $2 trillion economy grew 0.8 percent in the first quarter and the economy ministry has said growth may not exceed 0.5 percent this year. The central bank said the impact on growth of the ruble depreciation would be limited.
Analysts say Russia's external financial position remains strong. Its debt to GDP ratio stood at around 11 percent at the end of last year, compared to more than 100 percent among countries such as Italy or Greece.
(Additional reporting by Denis Dyomkin in Khabarovsk and Jason Bush, Vladimir Abramov and Elena Orekhova in Moscow; Writing by Lidia Kelly and Nigel Stephenson; Editing by Tom Heneghan)