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NBU Expects Inflation to Slow Significantly, Economy to Return to Recovery This Year – Inflation Report

NBU Expects Inflation to Slow Significantly, Economy to Return to Recovery This Year – Inflation Report

In 2023, inflation will slow to 14.8%, and real GDP will grow by 2%. In the following years, inflation will continue to decrease, and the economic recovery will accelerate as security risks embedded in the forecast ease. This is according to the April 2023 Inflation Report (released on a quarterly basis).

Inflation to decrease over entire forecast horizon 

With monetary conditions being tight, global inflation declining, and domestic demand staying subdued, Ukraine will see its inflation rate slow to 14.8% this year. Specifically, inflation is expected to drop sharply in H1 2023. In H2, the pace of growth in consumer prices will remain almost flat, primarily due to unevenly distributed base effects and the announced return of fuel taxes, which are intended to reduce pressure on public finances.
Inflation will fall to 9.6% next year, and to 6% in 2025. Inflation pressures stand to ease despite the revival of economic activity and the pursuit of a loose fiscal policy. This outlook is based on the assumption that security risks will decline in intensity with the arrival of 2024, and takes into account the continued recovery of logistics chains and production capacities, and the conduct of consistent monetary policy by the NBU. 

Monetary conditions will remain rather tight for a protracted time even if cuts to the key policy rate begin in Q4 2023. This is due to the expected pullback in inflation and a resulting increase in the real yield on hryvnia-denominated instruments. Consistent monetary policy, aimed at preserving the attractiveness of hryvnia savings, will make it possible to maintain exchange rate sustainability, including when FX restrictions are eased.

Thanks to the sustainable energy system and strong fiscal incentives, the economy will, as soon as this year, be back on track to recover 

Considering the energy system’s rapid revival, and growing amounts of anticipated international aid (that will be injected into the economy through budget spending and that will support private consumption and investment), the NBU upgraded its 2023 GDP growth forecast to 2%, up from a marginal 0.3%. A faster economic recovery will be impeded by the persistence of high security risks (which depress investment and consumer sentiments), by export disruptions, and by the slow return of forced migrants from abroad. 

In the years that follow, economic growth rates are expected to accelerate to 4.3% and 6.4%, respectively, primarily due to the easing of security risks, which is embedded in the forecast, and because fiscal policy will remain accommodative although some fiscal consolidation is expected. 

Employment and wages are seen to gradually rise as economy recovers, but unemployment will stay above pre-war levels 

In 2023–2025, assuming no new significant shocks occur, the labor market will continue to recover amid economic growth and a fairly loose fiscal policy. The unemployment rate will gradually decline: to 18.3% in 2023, to 16.5% in 2024, and to 14.7% in 2025. However, it will exceed the pre-war level, in part due to the likely persistence of significant mismatches, by skill and region, in the labor market.

Real wages will return to growth, although it will be moderate this year (3.7%) due to still-high inflation. Conversely, nominal wages will grow at double digits over the entire forecast horizon. After security risks abate and borders fully reopen, a large number of businesses will have to compete for workers, including against foreign peers. The rivalry to lure talent will become a strong factor in driving the subsequent growth in wages. 

International aid will continue to play a key role in financing the budget, but the role of domestic borrowing will increase 

Given sizable expenditures on defense and security, and the significantly narrowed funding base due to the fallout from the war, the budget deficit will expand to more than 26% of GDP in 2023. Going forward, the budget shortfall will slowly shrink. However, fiscal policy will remain accommodative throughout the forecast horizon, a condition that is particularly vital for bolstering the post-war economic recovery.

International financial aid will continue to be the primary way of financing the significant budget deficit this year. At the same time, domestic borrowing will grow in importance, partially due to the rising investment appeal of government securities as the risk premium and inflation subside. All of this will make it possible to continue to cover the budget deficit without resorting to monetary financing, a commitment that has been declared by the government and the central bank.

Although the level of debt on the forecast horizon is high, the debt burden in the years ahead will be relatively moderate thanks to preferential terms of new loans granted to Ukraine. 

The macro forecast primarily assumes that security risks will moderate significantly, from early 2024 forward, thanks to Ukraine’s military successes 

The most serious risk to the current forecast is therefore a higher intensity and a longer duration of the full-scale war. Under such a scenario, although businesses are expected to adjust to operating amid high security risks, economic growth in 2024 will be limited to 2%. In turn, the labor market’s recovery will decelerate. Inflation will be restrained by the extension of the moratorium on tariff increases for certain utilities, but will significantly accelerate after tariffs are allowed to rise. Should the scenario of a protracted war materialize, monetary conditions will remain tight longer. 

On the upside, a positive risk to the forecast is a rapid implementation of Ukraine's reconstruction. Accompanied by reforms needed for EU accession, such an expedited rebuilding effort will considerably speed up economic growth, reducing unemployment and raising incomes. The growth in incomes will not trigger significant pro-inflationary effects, because price pressures will be offset by favorable FX market conditions as the country receives FX inflows and the risk premium goes down. Under such a scenario, the NBU may ease its monetary policy faster than the current forecast envisages. 

On top of updated macroeconomic forecasts, the April Inflation Report features a number of special topics, including:

  • Europe's Natural Gas Prices: Time to Trend Down

Threats by russia to partially or completely cease natural gas supplies to Europe fueled a surge in gas prices in the EU market. However, Europe managed to make up for the loss of supplies through russian pipelines by accumulating large gas reserves (more than 90% of EU storages were full at the start of the heating season). What also helped were record imports of LNG and a significant drop in gas demand (by 15% in 2022) amid a warm winter. As a result, russia's gas blackmail failed to send the EU into energy meltdown. On the contrary, it accelerated the formation of a European gas market with a full-fledged pricing mechanism and competition.

However, the market remains vulnerable to supplies from russia, which, despite a decrease in its share, still accounted for about 15% of the EU's natural gas imports in Q1 2023. Competition from Asian countries to buy LNG will put additional pressure on the market, despite the global increase in LNG production. As a consequence, risks of elevated volatility of prices will persist, keeping them higher than before 2022. Meanwhile, the groundwork for structural changes laid by the EU's efforts to substitute away from the aggressor's gas has made it possible to expect a steady decline in gas prices on the European market in the coming years.

  • Owner-Occupied Housing Expenses Now Included in CPI: Impact on Inflation

At the beginning of 2022, the State Statistics Service of Ukraine conducted a planned review of the consumer basket that goes into the calculation of the CPI. The revision was aimed at further approximating the index to households' actual expenditures and aligning domestic statistics with global standards. A key innovation that resulted from the review was the inclusion of owner-occupied housing costs (expenses related to purchasing, maintaining, and inhabiting a dwelling) into the CPI. Previously, the index had incorporated only a portion of such costs.

Up until now, these changes have had no significant impact on the inflation gauge, although prices in this group have grown rapidly. This is due to the incremental share of owner-occupied housing costs in the CPI (just 0.43% in 2023). According to data from other countries, however, the weight and impact of this component on overall indicators of inflation may rise considerably, taking into account the expected post-war economic recovery and an accompanying development of the real estate and mortgage markets. Integrating owner-occupied housing expenses into the CPI formula will thus help to better inform decisions on monetary policy.

  • Assessing Accuracy of NBU's Macro Forecasts

The quality of the NBU's macroeconomic forecasts remains as good as the average projections of market participants. Specifically, the accuracy of the central bank’s inflation forecasts for 2016–2022 was higher than average and came out the best in terms of unadjusted errors of all other inflation forecasts. The accuracy of the NBU's key policy rate forecasts is conventionally higher than that of other market participants. Despite unprecedented uncertainty, forecast errors were relatively insignificant and primarily attributable to unexpected shocks, as well as the conservative nature of the scenario assumptions embedded in NBU forecasts, a practice that is common for central banks.

  • Ukraine's Wartime Labor Market

In the absence of relevant official data, estimating the impact of the full-scale war on the labor market is difficult and requires additional research techniques. Such additional observations were collected through a number of household surveys.

Based on these polls, the NBU adjusted its estimate of the unemployment rate in 2022. Using probit models to help its research, the NBU estimated the probability that a person will qualify as unemployed, depending on their socio-demographic characteristics. The most important attributes, the calculations showed, were age, place of residence, level of education, and macroregion of residence. A direct effect of the full-scale invasion was an increase in the probability of becoming unemployed in all of Ukraine’s oblasts. On the other hand, the liberation of russian-occupied territory had a direct and material impact on reducing this probability.

Alternative estimates of the labor market’s performance confirmed not only a significant increase in unemployment in Ukraine at the beginning of  the full-scale invasion, but also positive developments in the labor market in H2 2022. Based on these results, the NBU revised its estimate of unemployment in 2022 to 21.1% (down from 25.8%).

  • Factors That Sustain Ukrainian Exports as Full-Scale War Grinds On

The full-scale invasion of Ukraine by russia in 2022 posed unprecedented challenges for Ukrainian manufacturers and exporters. In addition to ruining production and storage capacities and fueling security risks and uncertainty, russia dealt an exceptionally heavy blow to the Ukrainian economy by blocking Ukraine's maritime transport routes (arteries that facilitated about two-thirds of Ukraine's foreign trade turnover before the full-scale war).

At the same time, food exports remained resilient even in the face of hostilities. In March–December 2022, it decreased less (by 27% yoy) than exports of other goods, mitigating the fall in total exports (45%). Moreover, in 2022, Ukraine retained its place among the top five global exporters of agricultural products and even diversified its exports in certain markets.

Food exports will continue to provide a solid foundation for the Ukrainian economy, including during post-war recovery, thanks to rerouted logistics, product recognition by European consumers, and better adaptation of Ukrainian merchandise to EU requirements. At the same time, an important long-run task in terms of honing the competitive edge of Ukrainian-made goods is to expand the share of high-tech products in the country's exports.

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