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NBU Raises the Key Policy Rate to 17.5%

The Board of the National Bank of Ukraine has decided to hike its key policy rate to 17.5% per annum, effective from 13 July 2018, aiming at bringing inflation back to the target range in 2019.

The NBU believes that a number of factors can pose a threat to  inflation decreasing to the target level – namely, a continued pickup in domestic demand, active labor migration, higher risks to receiving the next tranche from the International Monetary Fund and other related financing, excessively high inflation expectations, and lower investor interest to assets of developing countries. A tighter monetary policy will neutralize their effect, driving inflation down to 5.8% as of the end of 2019 and 5% in 2020.

June 2018 saw a substantial slowdown in consumer price inflation that reached 9.9% yoy, which was somewhat below the NBU’sforecast published in the April 2018 Inflation Report. This was primarily the result of a considerable increase in supply of food products on the back of more favorable weather and a rise in imports. In addition, a strengthening in the hryvnia exchange rate, which was driven in particular by the tightening of monetary policy by the NBU, had a favorable effect on the costs of imported goods and the prices of goods and services costs of which heavily depend on imports.

Core inflation also decelerated in June, to 9.0% yoy that was lower than expected. However, core inflation remaining high indicates that the underlying inflationary pressure is persistently strong. This is mainly the result of sustained growth in consumer demand, which is fueled by a rapid rise in incomes that substantially outpaces the rates of economic growth.

The impact of inflation factors will become stronger in future, but the tight monetary policy will offset their effect and drive inflation back to the target range in 2019.

The NBU keeps its inflation forecast for year-end 2018 unchanged at 8.9%. A faster-than-expected disinflation in May–June 2018 will be neutralized in the second half-year. This is due to expectations of a greater-than-expected increase in administered prices at the end of the year, which is aimed at bringing domestic gas prices closer to the import parity price, and the subsequent rise in utility services prices.

This factor will also influence inflation levels in the first three quarters of the next year, which will not allow the NBU to bring inflation to the target range before Q4 2019. However, this factor is beyond the reach of monetary policy and thus monetary policy tools cannot be used to neutralize it.

At the same time, in H2 2018 and 2019 inflation will be exposed to a number of factors that should be eliminated by monetary policy tools, unlike the rise in administered prices. Among them:

  • higher-than-expected domestic demand, which is, among other things, due to wage growth and greater remittances from labor migrants
  • less interest on the side of investors in Ukrainian sovereign debt as a result of the global trend of exiting developing countries’ assets and postponed financing under the IMF cooperation program
  • inflation expectations that continue to exceed the NBU’s inflation targets.

These are the factors which the Board aims to address with today’s decision to hike the key policy rate.

Under such conditions, the tighter monetary policy will be among the key factors to drive inflation down along the forecast path and bring it to the target range in Q4 2019. Therefore, the NBU makes no change to its inflation forecast for year-end 2019, that is 5.8%.

In 2020, inflation will decelerate to 5.0%, the mid-point of the target range (5.0% ± 1 pp).

After speeding up in 2018, economic growth will slightly decelerate.

The NBU believes that the forecast of 2018 real GDP growth of 3.4% is still relevant. Economic growth will continue to be mainly driven by private consumption, which in the current year will be fueled by the persisting high rate of growth in real wages on the back of high migration. Favorable terms of trade, a recovery in the industrial sector, together with greater access of Ukrainian exporters to foreign markets, will decrease the negative contribution of net exports to GDP.

In 2019, real GDP growth will slow to 2.5% (2.9% in the previous forecast), due to the waning effects of higher social standards, the tight monetary conditions required to bring inflation back to its target, as well as tight fiscal policy resulting from the need to repay large volumes of public debt.

In 2020, the real economy is expected to grow by 2.9%.  Private consumption, additionally supported by rising remittances thanks to an increase in the number of labor migrants, will remain the main driver of economic growth in the medium-term. Meanwhile, investment growth will be restrained by businesses’ higher labor costs. However, the contribution of net exports will remain negative over the forecast horizon, as imports will satisfy a significant portion of domestic demand and capital investment needs.

A key assumption of the above scenario is based on Ukraine continuing to carry out structural reforms, as provisioned in the IMF-supported program.

These reforms are essential to delivering macrofinancial stability and sustainable economic growth in the long-term. Access to the official financing provided by the IMF and other international lenders will enable the government to secure financing on the international capital markets on reasonable terms.

The NBU expects that all of the required reforms will be carried out, and that in 2018 Ukraine will receive about USD 2 billion in IMF loans, as well as loans from the European Union and the World Bank.  The aforesaid will ensure increase in the international reserves up to USD 20.7 billion by the end of this year.  However, in 2019–2020, the balance of payments is expected to run a deficit, and international reserves will stand at about USD 20 billion amid peak repayments on external public debt.

Accordingly, the main risk to the said macroeconomic forecast is that there may be no progress in implementing structural reforms, which is required for maintaining macrofinancial stability and continuing cooperation with the IMF.

Any delays in taking the actions assigned in IMF-supported program reduce the likelihood that Ukraine will receive financing from the IMF, and narrow further the country’s opportunities to secure financing on the international capital markets required for making public debt repayments, which will peak in 2018-2020. Therefore, receiving less than the planned amount will make financing budgetary spending more difficult.

The following risks remain important:

  • continued capital outflow from developing economies, due to the central banks of advanced economies tightening their monetary policies faster than expected
  • a global economic downturn in the wake of large-scale trade wars
  • persistently high labor migration.

At the previous monetary policy meeting that took place in May 2018, the NBU Board said it could raise the key policy rate further if risks to lower inflation and macrofinancial stability increased. In this light, in view of the need to offset the outlined factors that could put pressure on inflation in 2018 and 2019, and taking into account the higher probability that the outlined risks could materialize, the NBU Boards deems it necessary to tighten monetary policy by raising the key policy rate.

If there is good reason to believe that the above risks will increase further, or if new significant threats to lower inflation or macrofinancialstability appear, the NBU could raise the key policy rate again to a level required to bring inflation back to its target over the forecast horizon.

The decision to raise the key policy rate to 17.5% has been approved by NBU Board Key Policy Rate Decision No. 443-D, dated 12 July 2018.

A new detailed macroeconomic forecast will be published in the central bank’s Inflation Report on 19 July 2018.  

A summary of the discussion by Monetary Policy Committee members that preceded this decision will be published on 23 July 2018.

The next meeting of the NBU Board on monetary policy issues will be held on 6 September 2018 as scheduled.

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