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Inflation Will Keep Slowing and Economy Will Continue Recovering – NBU Inflation Report

Inflation Will Keep Slowing and Economy Will Continue Recovering – NBU Inflation Report

In 2023, inflation will slow to 10.6%, and real GDP will grow by 2.9%. In the next years, inflation will continue to decline, and economic recovery will accelerate. This scenario is based on the assumption that security risks will start to decline significantly from mid-2024. The NBU’s forecast also takes into account the consequences of russia’s terrorist attack on the Kakhovka Hydro-Power Plant and the termination of the grain corridor’s operation. The detailed analysis and macroeconomic forecast are published in the quarterly Inflation Report of July 2023.

Inflation will decline in 2023–2025 

In 2023, consumer inflation will slow to 10.6% and core inflation to 9%. This will be bolstered by the NBU’s measures to ensure the sustainability of the FX market as well as by the frozen tariffs on main utility services. The overall decline in global prices will also play an important role. On the other hand, faster disinflation will be impeded by the consequences of the destruction of the Kakhovka Hydro-Power Plant, which, among other things, will affect harvests of some fruits and vegetables. In addition, the return to the pre-war level of the fuel taxation will also impact consumer prices.

Inflation will continue to slow in the coming years. It is expected that more effective logistics routes will be set up and production capacity will start recovering after security risks subside. This will help reduce business costs and increase supply of goods, particularly food products. As a result, in 2024, consumer inflation will slow to 8.5% and core inflation to 7%. Monetary conditions remaining relatively tight will bring inflation closer to the upper bound of the NBU’s target range of 5% ± 1 pp in 2025, while core inflation will decline to around 3%. In the post-war period, the adjustment of administered prices and tariffs will make the main contribution to headline inflation. However, the adjustment will be gradual and will be accompanied by an expansion of social support.

Economic recovery will continue despite the challenges of the war

The NBU improved its real GDP growth forecast for 2023 to 2.9% (up from 2.0% in the April Inflation Report). This is attributed to the resilience of businesses and households to challenges of the war, faster recovery of domestic demand, and an upward revision of harvest estimates. 

After security risks subside, economic recovery will accelerate – to 3.5% in 2024 and 6.8% in 2025. This will be favored by the restoration of export logistics in the Black Sea, an improvement in business and consumer sentiments, and the expansionary fiscal policy. At the same time, the estimate of growth in 2024 was revised downward compared to the previous forecast due to the longer period of high security risks.

The economy will continue to remain below its potential level. This will be due to, in particular, the revival of the labor market, recovery of production capacity, and exporters’ return to previously lost markets happening rather slowly.

Economic revival will contribute to a gradual increase in employment and labor income

The unemployment rate will decrease gradually – to 19% this year and to 16.9% and 14.4% respectively in the next years. This will be mainly supported by the recovery of economic activity. However, the unemployment rate will remain higher than before the full-scale invasion due to the persistence of significant mismatches on the labor market. In particular, this will be explained by economic recovery being uneven across sectors and regions due to repercussions of the war. 

Economic recovery will also drive a gradual increase in demand for labor, thus pushing up labor income. After the war, it will be additionally propelled by stronger competition with foreign employers. The growth in labor income will recover already this year and will accelerate onward. It will grow in both nominal and real terms.

External assistance will make it possible to finance large budget needs and maintain international reserves at a high level in 2023–2025

In 2023, the budget deficit excluding grants in revenues is expected to stay at the last year’s level of more than 26% of GDP. Going forward, the deficit will narrow thanks to an increase in revenues – to almost 20% of GDP in 2024 and around 12% of GDP in 2025. At the same time, the fiscal policy will remain loose over the entire the forecast horizon, which will support the economic recovery.

International assistance will remain the main source for covering the sizeable deficits. External financing will exceed USD 42 billion in 2023. It will remain significant in the coming years, albeit decreasing gradually. At the same time, domestic debt funding will continue to increase in importance for covering budget needs. 

Disbursements of international assistance will also ensure net inflows of foreign currency over the forecast horizon. These inflows will enable Ukraine not only to cover its own import needs to support its defense capability and reconstruction, but also to replenish international reserves, which will reach USD 44.1 billion at the end of 2025.

The NBU will reduce its key policy rate gradually, so as to keep hryvnia instruments attractive. Monetary conditions will remain tight for a long time

In view of favorable macroeconomic trends, the NBU cut its key policy rate in July, from 25% to 22%. The NBU’s revised macroeconomic forecast envisages further key policy rate cuts. At the same time, this will be done gradually, so as to keep hryvnia instruments attractive. This will reduce risks to FX market sustainability and disinflation, and will help implement the Strategy for Easing FX Restrictions, Transitioning to a More Flexible Exchange Rate, and Returning to Inflation Targeting.

The easing of the interest rate policy will support economic revival. As security risks subside and the macroeconomic environment improves, bank lending on market terms will recover and will become an additional impetus to sustainable economic growth.

Apart from the updated macroeconomic forecasts, the July Inflation Report features a number of highlights, including:

  • A short-term forecast of global steel and iron ore prices

Global commodity prices tend to be highly volatile over the short term. This volatility can have a substantial impact on macroeconomic performance of countries that export or import these commodities. Before russia’s full-scale invasion, Ukraine was significant global exporter of steel and iron ores. However, even under conditions of war, destroyed or damaged production facilities, and limited logistics, iron ores and metallurgical products account for about one fifth of goods exports.

Therefore, the NBU has developed several models for short-term (six-month) forecasting of global prices for these goods. The results produced by these models serve as a starting point for the long-term forecast of global and export prices, which, among other things, underlies the preparation of macroeconomic forecasts and monetary policy decisions.

  • The repercussions of the destruction of the Kakhovka Hydro-Power Plant

russia’s destruction of the Kakhovka Hydro-Power Plant will primarily have large-scale and long-lasting humanitarian and ecological consequences. The effect on the economy will be moderate in the current year – an up to 0.2 pp negative contribution to real GDP growth, an up to 0.3 pp positive contribution to consumer inflation, and a widening in the deficit in the trade in goods by USD 0.4 billion. All these are factored into the NBU’s forecast. In the coming years, these losses will decrease, but they will be permanent and will affect potential GDP over a long period of time, while also restraining a decline in inflation.

  • The effect of Ukraine’s military aid on the economies of partner countries

While conducting an information war, russia is spreading the narrative that Ukraine’s partners are supposedly spending too much money for the country’s military support, while their economies are suffering from accelerating inflation and slowing economic growth. However, available studies provide convincing evidence that the economic costs of military aid for Ukraine is significantly lower for the country’s partners than the announced nominal amounts.

The preliminary results of a study conducted by Chebanova, Faryna, Sheremirov (2023) show that ramping up military spending on the war in Ukraine in the short-term has a stimulating effect on the GDP of partner countries. More specifically, every USD 1 spent on military needs by the governments of donor countries, over the course of one to two years adds USD 0.79 to 0.87 to the GDPs of these countries. Overall, the positive effect does not disappear even after five years. Moreover, there are a number of additional positive effects for donor countries, such as the possibility of sharing military experience, a more efficient allocation of defense industry resources, impetus for arms exporters, and increased productivity through additional investments in research and development.

  • The transmission of the NBU’s key policy rates to interest rates on hryvnia term household deposits

Influencing bank deposit rates with a view to encouraging households to save more is an important transmission channel of monetary policy. This is especially the case under current conditions, when other transmission channels are rather weak because of the fixed exchange rate and a high risk premium. This effect is mostly achieved through changing the key policy rate and the operational design of monetary policy. In June 2022, the NBU raised its key policy rate significantly, from 10% to 25%. This reversed the downward trend in deposit rates. However, in late 2022, the monetary impulse began to weaken, mainly due to a widening liquidity surplus.

The NBU's study shows that deposit rates respond to a change in the key policy rate gradually, asymmetrically and to a different degree, which could vary over time. For instance, banks are usually more willing to cut deposit rates than to raise them (in particular, in order to reduce interest expenses). In addition, the NBU estimates that in Ukraine the key impact on the extent of monetary transmission through the deposit channel comes from economic uncertainty, the amount of liquidity and the strength of competition in the banking system, inflation, and monetary policy measures.

A change in the key policy rate first affects interest rates on interbank loans (measured by the UONIA index in Ukraine), and only over time does it pass through to deposit rates. A study carried out by the NBU shows that the strongest impact from a change in the key policy rate on deposit rates occurs over the eight to 18 months horizon. When interbank rates rise by 10 pp, deposit rates in Ukraine increase on average by almost 5 pp over the next 12 months; when interbank rates drop by 10 pp, the banks cut their deposit rates by about 6 pp.

Central banks can deploy additional tools to speed up monetary transmission. More specifically, in 2023 the NBU noticeably increased the required reserve ratios for banks, changed the rules for calculating these ratios, and altered the operational design of its monetary policy. These measures helped enhance monetary transmission and make hryvnia assets much more attractive to households. This made it possible to maintain the sustainability of the FX market and, consequently, disinflation.

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