In line with the Monetary Policy Strategy for 2016–2020, the NBU has moved away from a de facto fixed exchange rate to an inflation targeting regime. Under this approach, quantitative inflation targets are published and the central bank commits to meet those targets over the medium term. However, the NBU has no control over setting prices for goods and services. How, then, does the NBU influence inflation?
The key interest rate is the main tool available to central banks to influence inflation. For the NBU, that is the key policy rate. As a rule, central banks make regular decisions on the key rate: to leave it unchanged or to increase or decrease the rate. The NBU Board makes decisions on the key policy rate based on a schedule made public in advance and announces the decision at a press briefing at 2 p.m. after the board’s monetary policy meeting. The key policy rate was reviewed nine times in 2017, and eight reviews are planned for 2018.
The process by which the key rate influences inflation is called the transmission mechanism of monetary policy.
Initially, by changing the key policy rate, the NBU determines the level of short-term interest rates in the interbank market. In turn, the interbank rates influence aggregate demand and inflation, especially by changing the expectations of households and businesses. This influence takes place through various channels, including interest rates, the stock exchange, and foreign exchange market. The management of expectations is effective when the public trusts the regulator as a result of an understandable and consistent inflation targeting policy. This enhances the effectiveness of monetary transmission.
The monetary transmission mechanism takes time. For this reason, central banks aim to be proactive, relying on their macroeconomic forecasts. In Ukraine, a change in the NBU’s key policy rate has a major effect on inflation within 9–18 months. Therefore, the NBU’s monetary policy decisions are not a reaction to past events, but a response to expected future developments.
Effect of the NBU’s Key Policy Rate on Short-Term Interbank Interest Rates
The effect of a change in the key policy rate on short-term money market rates (interbank market) is the first link of the monetary transmission mechanism. Usually, central banks are quite effective in controlling short-term rates by regulating bank liquidity: if there is a liquidity surplus, central banks absorb excessive liquidity; if there is a liquidity deficit, they inject funds into the banking system.
In the former case, the NBU sells certificates of deposit and may also sell government securities from its own portfolio or perform reverse repo transactions (sale of a security with an obligation to repurchase it after a specified period of time). In a liquidity deficit, the NBU may issue loans to commercial banks and accept liquid collateral. The NBU may also buy government securities for its own portfolio or engage in repo transactions.
By setting the key rate, a central bank signals to the market about the level of rates it considers optimal for achieving its monetary policy goals. In order to bring market rates closer to the level desired by the central bank – i.e., to the key rate – it pegs its transactions to the key rate. In particular, under the current conditions of a liquidity surplus, the NBU’s main operation is selling two-week certificates at a rate equal to the key policy rate.
In order to dampen market volatility, the NBU also applies standing facilities involving certificates of deposit (at 2 pp below the key policy rate) and overnight loans (at 2 pp above the key policy rate).
The central bank’s influence on short-term interbank rates is prompt and effective as long as the central bank does not set any additional restrictions when attracting or issuing short-term facilities. Commercial banks can transact either with the central bank or with each other. For this reason, short-term interbank rates usually range in between the central bank’s rates for certificates of deposit and overnight loans and are near the key rate.
The NBU has been determining the key policy rate since it was established in 1992 (complete history of key policy rate values), but the key rate had little impact on bank rates before 2015. Until then, the NBU did not use it as a policy tool: interest rates on the NBU’s main transactions were not pegged to the key policy rate. The current system enables the NBU to effectively manage short-term interbank rates, to maintain them close to the key policy rate.
Transmission of Short-Term Rates to Long-Term Rates and to the Real Sector
Medium- and long-term interest rates are a more important tool for influencing economic processes. At these rates the banking system attracts temporarily free funds and directs them to where they are needed. Medium- and long-term rates on bank deposits and loans depend on both short-term interbank rates and on the structural characteristics of the economy and the financial system (competition within the banking system, trust in banks, inflation expectations, demand for loans, supply of financial resources, etc.). The relationship between short-term interbank rates and rates on bank loans and deposits grew much stronger in 2016–2017. This occurred after the NBU adjusted the short-term rate management system. As a result, the volatility of short-term rates decreased substantially and banks gained a reliable indicator of money value in the market and an easy way to transact with the NBU to manage liquidity.
Changes in bank interest rates influence decisions households and businesses make, particularly regarding the choice between consumption/investment and savings. For example, when deposit interest rates grow, households tend to save more and consume less in the short-run. When lending rates increase, businesses invest less due to expectations of higher loan payments and a decline in demand for their products as consumers cut consumption. Therefore, rate growth leads to a decrease in consumer and investment spending and an increase in savings.
A decrease in aggregate demand for goods and services restrains price growth, while growth in aggregate demand results in higher inflation.
The conditions in the Ukrainian banking system in 2012–2013 are a clear example of the effect high rates have on expectations of low inflation and a stable exchange rate. Despite the recession that began in the second half of 2012, growth in hryvnia retail deposits accelerated when real interest rates (nominal rates less inflation) increased substantially, which was one of the reasons why inflation was near zero in those years.
Short-term interest rates also influence long-term rates on the financial market, especially yields on government securities (domestic government bonds). These securities are the safest debt instruments on the market; their price includes the lowest risk premium and their yields serve as a benchmark for investors to assess the return and risk of investing in other securities.
The maturity of domestic government bonds varies from several months to several years. Yields on domestic government bonds of various maturities forms the so-called yield curve, which shows the relationship between yield and term of investment.
In addition to the interest rate and stock exchange channels, the key policy rate also passes through to the economy through the exchange rate. This is an especially important channels for economies with substantial foreign trade and/or foreign capital flows.
Key Policy Rate Transmission via the Exchange Rate
Changes in the exchange rate are another important channel of key policy rate transmission. In developed economies with a free flow of capital, the exchange rate channel allows one to borrow funds in a country with lower interest rates and buy bonds (or other instruments with yields linked to the rate, like deposits) in another. In this case, a rate increase should boost foreign currency inflows, which, in turn, raises demand for domestic currency and strengthens it.
Besides this effect, Ukraine issues government bonds with various yields both in hryvnia and in foreign currency. Thus, if an increase in the key policy rate triggers growth in yields on hryvnia domestic government bonds but not foreign currency bonds, investors may sell foreign currency bonds and buy hryvnia bonds (with other factors being unchanged). Likewise, individuals can choose between domestic currency and foreign currency deposits. This means rate changes influence the supply and demand balance of foreign currency, and, therefore, the exchange rate.
The Consumer Price Index (CPI) includes both imported goods and domestic goods that compete with imports. For many importers, who compete with one another, exchange rate changes lead to a correction of final prices for imported goods. When the hryvnia strengthens against the dollar, one can buy more goods for dollars while spending the same amount in the hryvnia, which means that imports grow in dollar terms.
At the same time, Ukrainian goods, the price of which are determined by hryvnia costs, become more expensive in the dollar equivalent. This makes Ukrainian goods less competitive on global markets. As a result, inflation pressure subsides, but the balance of trade deteriorates at the same time.
CPI includes final consumption goods, but Ukraine also imports raw materials, which influences the final prices of consumer goods. Fuels and lubricants (mostly imported in Ukraine) are a clear example, as they are included in the cost of practically all products due to transportation costs. For this reason, the exchange-rate-driven change in hryvnia prices for imported raw materials also impacts consumer prices, which occurs with a delay.
Research of exchange rate pass-through to prices shows that inflation response differs depending on the pace of exchange rate changes. A minor change in the nominal effective exchange rate (up to 3% per quarter) has a substantial impact on inflation: 1% change in the exchange rate shifts inflation by 0.71%. A major change (over 16%) has a considerably lower impact on inflation. A moderate change in the exchange rate (from 3% to 16%) has practically no effect on inflation. In addition, an appreciation of the exchange rate has a much lower effect on prices than a depreciation.
Time Lags in Key Policy Rate Transmission
Transmission via any channel takes some time. That time is typically measured in quarters. For example, in Ukraine, it takes 9–18 months for a change in the NBU’s key policy rate to have a major effect on inflation. Therefore, central banks often change the key rate at times when the need for that shift is not obvious based on available inflation data. For example, central banks often reduce key rates amid growing current inflation or hike rates when inflation is on the decline. This is because central banks focus mainly on the most probable future trends rather than on current inflation.
A central bank that pursues inflation targeting should influence inflation expectations by reinforcing the confidence of businesses and households in its ability to bring inflation to the target over the medium term.
Under these conditions, inflation does not hinder sustained economic growth. Inflation expectations determine long-term inflation trends that are the basis for decisions made by:
- businesses – when making decisions on investments, loans, product prices, and production resources
- households – when deciding on distributing disposable income into consumption and savings, as well as on the optimal form of savings.