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Inflation to Remain Subdued, Economy to Recover – NBU Inflation Report

Inflation to Remain Subdued, Economy to Recover – NBU Inflation Report

Inflation will accelerate moderately in 2024, but will enter the NBU’s target range next year, declining to 5.8%. In 2026, inflation will decrease to 5%. The economic recovery will continue, but it will slow to 3.6% in 2024. In the next two years, GDP growth is expected to accelerate to 4–6% per year. This forecast is based on the assumptions that high security risks abate from 2025 and that significant international aid inflows continue. The detailed analysis and macroeconomic forecast can be found in the quarterly Inflation Report for January 2024.

Although inflation stands to accelerate in 2024, it will remain moderate and return to the target range in 2025

Consumer inflation eased to 5.1% yoy at the end of 2023 due to the significant supply of food products, less pressure on business costs, and continuous exchange rate sustainability. In the first months of 2024, consumer inflation will remain close to current levels, but will edge higher in H2 2024 to reach 8.6% at the end of the year. This will primarily be driven by the fading effect of extremely favorable weather on the supply of foods and by the growth in business costs, including the compensation of employees.

As security risks recede, inflation will slow to 5.8% in 2025 and return to the 5% target in 2026. This will be facilitated by both an easing of external inflationary pressure, partially due to cheaper energy, and the NBU’s consistent monetary policy.

To keep inflation subdued in 2024 and bring it to the target in the following years, the NBU will continue to pursue a monetary policy that supports exchange rate sustainability. Safeguarding the attractiveness of hryvnia instruments – by maintaining a level of interest rates on hryvnia deposits that protects hryvnia savings from losing value – will remain one of the NBU’s important tasks.

Economic growth will decelerate in 2024, but will pick up going forward

Thanks to higher-than-expected harvests of late crops, as well as greater adaptability of households and business to crisis conditions, the NBU has upgraded its estimate of real GDP growth in 2023 to 5.7% from 4.9%. Loose fiscal policy, which helped revive consumer and investment demand, was a significant factor in improving the estimate.

In 2024, real GDP will continue to grow, albeit at a slower pace (3.6%). The recovery will be driven by loose fiscal policy, a further strengthening of domestic demand, and an expansion of supply chain capacity. However, security risks will continue to run high, a factor that together with the scale of losses and destruction will restrain economic growth. A likely drop in harvests after last year’s record yields will also have an impeding effect. 

In 2025–2026, economic growth will accelerate to 5.8% and 4.5%, respectively. Expectations will generally improve as security risks ease off. This will make it possible to optimize supply chains and restore production. The stimulating effect of fiscal policy will also endure. However, the fallout from the war, including massive destruction and labor market mismatches, will weigh the economy down as it recovers. Ukraine’s GDP will approach its potential level at the end of 2025, but will not return to pre-invasion levels over the forecast horizon.

Economic recovery will be accompanied by higher employment and rising household incomes

Labor demand went up in 2023. The number of new vacancies almost returned to the level of 2021. However, the labor market’s revival is significantly hampered by war-induced structural mismatches and labor shortages. So the unemployment rate will decrease moderately to 16.2%–12.2% in 2024–2026, down from 19% in 2023. At the same time, unemployment will remain above its natural rate due to the adverse impact of the war.

Personal incomes returned to growth in 2023, both in nominal (up 17.1%) and real (up 3.5%) terms (i.e. after subtracting inflation). Household incomes will continue to grow as the economy revives. In the post-war period, income growth will also be driven by intensified competition for workers between Ukrainian and foreign employers.

International aid will remain an important source of financing the budget deficit and capital inflows from abroad

Driven by high expenditures on defense and security, the budget deficit will be significant (20.7% of GDP) in 2024, but smaller than last year. International aid will continue to be a substantial source of funds to cover the budget deficit. Ukraine stands to receive about USD 37 billion in aid this year. International financing is expected to decline in the coming years, but only gradually, without posing risks to the sustainability of public finances. The easing of security risks and the strengthening of the domestic funding base amid an economic revival will make it possible to reduce the budget deficit in 2025–2026 to 13.5% and 7.5% of GDP, respectively.

External support in 2024 will also fully make up for the still-high FX outflows from the private sector. Investment and borrowing by the private sector will increase as security risks die down going forward, and households’ demand for foreign currency will subside. The global economic revival will facilitate an increase in income from IT services and remittances. Imports of travel services are also expected to decrease. As a result, Ukraine’s international reserves are projected to fluctuate within the USD 37–42 billion range in 2024–2026 and will be sufficient to ensure exchange rate sustainability.

In addition to the updated macroeconomic outlook, the January Inflation Report features a number of special topics, including:

  • Factors That Brought Inflation to Its Target in 2023

The NBU’s priority task is to maintain price stability. After inflation spiked in 2022, price pressures eased off significantly to 5.1% at the end of the year. Key factors in relieving price pressures were:

  • a drop in the costs of raw materials and logistics due to the gradual adjustment of supply chains, the development of alternative logistical routes, and extremely favorable weather conditions
  • monetary policy measures aimed at maintaining exchange rate sustainability and the attractiveness of hryvnia savings instruments 
  • a decrease in global energy prices, specifically for oil (which almost made up for the impact of reimposed fuel taxes) and natural gas.

The list of factors that drove up inflationary pressure includes both the recovery of consumer demand and significant mismatches in the labor market. These fueled wage growth, which passed through to prices via companies’ production costs.

  • Development of Ukraine’s External Trade Routes: Time to Take Back What’s Ours

Ukraine is gradually winning back its positions on international markets by developing alternative transport routes. The role of roads and railways increased in 2022–2023. Ukraine managed to ensure that its maritime transportation continued despite multiple challenges. Specifically, the potential for Danube navigation expanded substantially: transportation in 2023 increased to six times the level of 2021. The Black Sea Grain Initiative was operational between July 2022 and July 2023. It channeled about one-third of total goods exports in its most productive months. After it terminated, a new sea corridor was established with strong support from Ukraine’s defense forces and international partners. Its performance in December 2023 surpassed that of the Black Sea Grain Initiative’s best months. In addition, the sea routes have been conveying not only food products, but also other exports and test deliveries of imported goods.

The available transport capacity will be sufficient to handle exports of harvests gathered in 2023–2024 and ramp up physical volumes of exports of other commodities, including those made by the metals-and-mining sector. What is more, the sea corridor will expand the geography and nomenclature of trade and revive production in certain branches of the economy. Diversification of transportation routes will reduce logistical risks and facilitate a rerouting of supply chains. The role of maritime transport in foreign trade will increase as passage via the sea corridor becomes more secure. This will help drive down the cost of logistics and improve the competitive edge of Ukrainian goods in foreign markets.

  • International Experience Applying Various Systems to Build Operational Designs of Interest Rate Policy

With economies receiving massive stimulus injections, many central banks are facing the challenge of reining in the structural liquidity surplus in their banking systems. It significantly limits the effectiveness of the key policy rate in building the operational design of interest rate policy based on the conventional symmetric corridor system. Alternatively, an operational design built around the floor system enables a central bank to more efficiently achieve its goals amid a significant sustained increase in the liquidity surplus.

Central banks in the United Kingdom, Canada, and New Zealand officially operate the classic version of the floor system, while South Africa and Norway deploy modifications of its operational design that use quotas. A number of other central banks have de facto been using the floor system without officially abandoning the symmetric corridor system. These include the ECB and at times the central banks of the Czech Republic and Poland.

The NBU switched to a modified floor system in October 2023 that accounts for the anticipated preservation of banks’ liquidity surplus over the forecast horizon. The specific feature that distinguishes the NBU’s operational design is the conduct of transactions with limited three-month certificates of deposit at a rate that is 4 pp above the key policy rate. They incentivize banks to compete for depositors and maintain attractive yields on retail hryvnia instruments, which is important for maintaining exchange rate sustainability and subdued inflation.

  • FX Interventions by CEE Central Banks: Lifebuoy Even for Those Who Float

Central banks are widely believed to usually make FX interventions either when the exchange rate is fixed or during crises. However, countries such as those of Central and Eastern Europe are known to have successfully used FX interventions under different regimes and macroeconomic conditions, achieving significant positive effects for their monetary policies and economies in general. In particular, the central banks of Bulgaria and Croatia conducted FX interventions (until 2023) when euro exchange rates were de facto fixed, while the National Bank of Romania intervened under a dirty float. The Magyar Nemzeti Bank pursues a free float, but uses FX interventions discretionally to prevent excessive exchange rate fluctuations. Meanwhile, Narodowy Bank Polski, which makes active use of its inflation targeting regime, also leaves room for the possibility of carrying out interventions to preserve macroeconomic and financial stability.

Overall, interventions are made to smooth out short-term exchange rate volatility, minimize external shocks, and mitigate risks to financial stability. How effectively actual FX interventions perform can be enhanced by targeted communications (press releases, briefings, comments, etc.), which are especially important in times of turbulence. Accumulating FX reserves as a buffer against future shocks can further boost confidence in a central bank.

The NBU also uses FX interventions under managed flexibility of the exchange rate, a regime the regulator switched to in October 2023. These interventions are intended to compensate for the structural deficit of foreign currency and smooth out excessive exchange rate fluctuations. Considering the significant sensitivity of inflation expectations to the exchange rate, the combination of conventional interest rate policy and FX interventions appears to be an optimal regime to pursue. Preserving exchange rate sustainability through FX interventions will contribute to macrofinancial stability and enable the NBU to achieve its inflation target in the medium term.

  • European Integration and Scenarios of Accelerated Economic Growth in Ukraine

The Ukrainian economy is gradually recovering, primarily by making up for the losses caused by russia’s full-scale invasion. However, sustainable and significant economic growth is only possible if productivity rises at a steady pace. This can be achieved through reform and closer alignment with more-developed economies, provided macrofinancial stability is maintained. Ukraine’s European integration efforts should become the driver of these processes.

Even prior to formal EU accession, the prospect of European integration will stimulate foreign trade, attract investment, and strengthen the country’s institutional capacity. The experience of other countries shows that economic growth incentives are created by actually meeting pre-accession requirements. Reforms, among other things, will increase the efficiency of the use of resource potential, reduce corruption, and deepen market-based competition.

The NBU has run model simulations to look into two development scenarios – moderate and favorable – that primarily differ by completeness of reforms and speed of European integration. Should reforms gradually move forward within the framework of European integration, Ukraine can grow by approximately 4% in the coming decade. A rapid transformation, however, could propel economic growth to about 7% a year.

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