The Board of the National Bank of Ukraine has decided to keep its key policy rate at 12.5% per annum. This decision resulted from the need to reduce risks to achieving the inflation targets set for 2017 and 2018.
Overall, inflation was kept in check. Although headline inflation has increased in recent months, as expected, core inflation has been stable.
Headline inflation sped up to 13.5% in May and to about 15% in June, as estimated by the NBU. These inflation figures were slightly higher than those projected by the NBU in its Inflation Report (April 2017). This was mainly attributed to a rise in raw food prices. An increase in global meat and dairy products has pushed up exports of Ukrainian products, cutting the supply of these products on the domestic market. The partial crop loss due to spring frosts and an increase in the supply of more expensive imported products have affected domestic fruit and vegetable prices.
In the meantime, core inflation was lower than expected, making up 6.5% in May. It was reined in by consumer demand, which was lower than its potential level, as well as by prudent fiscal and monetary policies.
A significant improvement in inflation expectations, resulting, among other things, from favorable FX market conditions, helped reduce the pressure on prices. The UAH/USD exchange rate has been strengthening since early 2017, driven by a hike in global steel and grain prices and larger agricultural exports. Meanwhile, in spite of a large supply of foreign currency on the domestic market, the demand for it remained depressed. Indeed, a gradual easing of FX restrictions did not have any material influence on the FX market. The NBU, although remaining committed to a flexible exchange regime, did not counteract the gradual appreciation of the hryvnia, while purchasing an excess supply of foreign currency in the interbank market to replenish international reserves. Overall, since the start of the year, the NBU has purchased over USD 1.3 billion net, pushing up reserves to USD 18 billion.
Inflation is projected to decrease to its target levels in 2017 – 2018
The NBU forecasts that inflation in 2017-2018 will meet the announced targets set in the Monetary Policy Guidelines for 2017 and Medium Term (8% ± 2 pp for 2017 and 6% ± 2 pp in 2018). The NBU has not changed its inflation projections for 2017-2018 forecasting inflation of 9.1% for 2017 and 6.0% for 2018.
In the latter half of 2017, inflation in annual terms is expected to be rather volatile, as it was in the first half of the year. In Q3 2017, it is forecast to remain in the double-digit range. However, in Q4, it is expected to return to a one-digit figure.
Inflation projections are expected to be unchanged due to various factors counterbalancing each other.
On the one hand, projections of a raw food price increase have to be revised upwards, driven by factors arising from the supply of these products.
On the other hand, this will be partly offset by weaker than so far expected growth in administrated prices. Influencing this also are more favorable than expected FX market conditions. As a result, the NBU has revised its core inflation projections downwards, to 6.1% at end-2017.
Core inflation is projected to decrease to 3.9% in 2018. Key to inflation continuing on its downward path will be prudent monetary and fiscal policies, which will revive consumer demand, improve inflation expectations further, and prevent considerable fluctuations in the exchange rate. Raw food price growth is expected to be significantly weaker in 2018 compared to the current year.
As in previous years, administrated prices will be driven by the inflation rate next year. These prices are forecast to rise by over 10%, reflecting expected growth in global energy prices, as well as Ukraine’s excise policy.
The NBU has revised its 2017 real GDP growth projections
The economic growth will slow down to 1.6% in the current year. The forecast was revised due to the worse economic performance in the first half of the year, particularly in services, and the revised crop yields assessments. Industries most susceptible to the breach of production ties with the uncontrolled territories (the mining and metals sector, energy industry, transport industry) will continue to underperform.
Real GDP growth will increase to 3.2% in 2018. First of all, it will be driven by gradual easing of monetary and fiscal policy that will stimulate consumer demand. Also, economic growth will be bolstered by the strengthening investment attractiveness of the economy and the exports growth against background of better terms of trade and high crop yields. However, the recovery of domestic consumer and investment demand will largely be met by imported products.
The current account deficit is expected to remain substantial at 4% of GDP in 2017-2018. It will be fully covered by inflow to the financial account that will provide for the further accumulation of the international reserves.
The key assumption of this forecast is further cooperation with the International Monetary Fund, which remains an important source of replenishing the country’s international reserves. Along with the surplus of consolidated balance of payments, the receipt of planned tranches under the EFF program will increase the international reserves to USD 20 billion by the end of 2017 and to USD 27 billion by the end of 2018. Also, the accumulation of reserves will be facilitated by the Government's use of special confiscation funds for the public debt servicing.
The NBU considers that the current level of the key police rate is consistent with the inflation targets for 2017-2018 and the present balance of risks.
The current state of monetary policy is kept to offset the effect of price growth on unprocessed foods on the inflationary expectations and the effects of consumer demand recovery, in particular, through the planned increase in pension payments from October in the form of increased inflationary pressure.
The risks of an upward or downward change of the inflation forecast for this year are estimated as equally probable. On the one hand, the possibility exists that administered prices may grow this year (which, however, will ease inflation pressure next year). Supply-side factors related to food products may exert stronger pressure on the inflation trajectory in the current and next year than it is now expected. On the other hand, global energy prices may be lower than those projected in the NBU’s baseline scenario. This will directly influence domestic consumer prices, and will also have an indirect impact through lower cost of imports with a correspondent adjustment of the exchange rate.
The mid-term outlook takes into account some uncertainties related to the pace at which the government is set to raise social standards, particularly, pensions, as well as possible changes in the state policy on providing subsidies to households. Further, there is continuing uncertainty about the implementation of the macroeconomic policy and structural reforms required to maintain macrofinancial stability, boost the economy’s potential and continue cooperation with the IMF. Unsuccessful reforms may undermine economic growth prospects, adversely affecting inflation and exchange rate expectations and increasing inflationary pressure. Apart from that, there is still a high risk that the military conflict in eastern Ukraine will escalate.
For the key policy rate to be reduced further, the NBU needs to have clear indications that the above stated risks would not translate into a stronger inflationary pressure and impede the achievement of inflation targets in the medium term. The NBU Board is confident that a sustained and substantial lowering of lending rates for the real sector is only possible provided the achievement of price stability.
Apart from that, the monetary policy easing witnessed this year can further facilitate the economic growth, since its effect has not yet fully translated into lower interest rates offered by banks, especially state-owned banks.
The decision to keep the key policy rate at 12.5% is approved by NBU Board Decision No. 418–D On the Key Policy Rate, dated 6 July 2017.
А new detailed macroeconomic forecast will be published in the Inflation Report on 13 July 2017.
The next meeting of the NBU Board on monetary policy issues will be held on 3 August 2017 as scheduled.