The Board of the National Bank of Ukraine has decided to raise the key policy rate to 25% per annum. Along with other measures, this resolute step aims to protect households’ income and savings in the hryvnia, raise the attractiveness of hryvnia assets, reduce the pressure on the foreign exchange market, and thus enhance the NBU’s capability to maintain the stability of the exchange rate and restrain inflation processes during the war.
Changes in consumer and economic behavior of businesses and households require returning to market-driven financial system management
At the start of the large-scale russian aggression, the NBU decided to refrain from taking any key policy rate decisions. This approach was justified by a strong psychological pressure caused by the war. Therefore, changing the key policy rate was unlikely to stabilize expectations and encourage keeping hryvnia assets, in particular to support the fixed exchange rate. The NBU aimed its monetary policy measures primarily on ensuring uninterrupted functioning of the banking system and payments in the economy. Fixing the exchange rate was supported by FX restrictions imposed to reduce demand for foreign currencies and the NBU’s interventions to sell foreign currency in order to cover the remaining FX deficit of on the interbank market.
At the same time, the gradual adaptation of Ukraine’s economy and the psychological shock giving way to the economic decision-making logics of businesses and households require changing the approach to monetary policy. As yields on hryvnia assets are low now, the threat has grown that the economy dollarization might rise and the financial system might lose respective resources. Depreciation expectations of households and businesses are not stable and are susceptible to war developments, in particular to changes on the frontline and other situational factors. As a result, the NBU has increased its interventions to sell foreign currency, from the monthly average of USD 2 billion in March–April to USD 3.4 billion in May. In addition, the difference in the cash market exchange rate and the official one widened in May, which worsened negative effects on the economy from existence of multiple exchange rates caused by restrictions on FX transactions and cross-border transfers.
Although Ukraine’s international reserves are still sufficient thanks to funding from international partners, risks to macrofinancial stability have risen in the medium term. If yields on hryvnia assets do not rise sufficiently, international reserves will keep depleting rapidly and imbalances will build up in the economy.
Inflation development requires the NBU to return to active interest rate policy in order to prevent a further deterioration in inflation expectations and dollarization of the economy.
In April, inflation accelerated to 16.4% yoy. In particular, core inflation rose to 13%. In monthly terms, prices grew by 3.1%. According to the NBU’s preliminary estimates, inflation continued to accelerate in annual terms in May.
Inflation was curbed by a certain recovery in economic activity, gradual setup of logistics, and an increase in supply from both domestic producers and importers. Relatively low demand and excess of agricultural raw materials also restrained the price growth. Measures taken by the NBU also played an important role, in particular fixing the exchange rate of the hryvnia and limiting exchange rate fluctuations on the interbank market, which was reflected in prices of goods and services of critical imports. Administrative caps on prices imposed by the government also reined in inflationary processes. The liberation of Ukraine’s northern regions (Kyiv, Chernihiv, and Sumy oblasts) and the Ukrainian army’s resistance against the enemy in southern and eastern regions restrained the deterioration in inflation expectations.
At the same time, the disruption of production and logistics by the war is fueling inflation. High global energy prices also remain a significant inflationary factor, putting pressure on consumer inflation, both directly and indirectly, through higher production costs. Global inflation is also at a record-high. In particular, the inflation rate in the United States and euro area countries is over 8%. This factor is also pushing up domestic prices.
Despite the gradual recovery of the economy, the upward trend in inflation will continue in the coming months.
This could worsen inflation expectations even further, and encourage depositors to convert their hryvnia savings into FX ones. The NBU’s return to an active interest rate policy will prevent these negative trends.
A decisive rise in the key policy rate will spur investors’ interest in hryvnia assets, while also easing pressures on international reserves and reining in inflation.
After considering several scenarios, the NBU decided to raise the key policy rate by a whole of 15 pp, to 25% per per annum. The NBU believes that a slight increase in the key policy rate would have had no significant influence on the financial and economic system. The first reason for this is that the monetary transmission mechanism has only a limited effect in wartime. Second, this would have resulted in expectations of further increases in the key policy rate and, consequently, depositors taking a wait-and-see approach and, investors having weak interest in hryvnia assets. Third, to revive interest in hryvnia assets, their yields must exceed expected inflation rates.
The NBU has also decided to widen the interest corridor for monetary transactions with banks to provide additional room for reviving the interbank market. More specifically, from 3 June, the interest rate on refinancing loans will equal the key policy rate plus 2 pp, while that on certificates of deposit will be the key policy rate less 2 pp.
The NBU expects that the government and the banks will respond adequately to the hike in the key policy rate by raising interest rates on domestic government debt securities and deposits. An appropriate response of market interest rates to the key policy rate hike will make hryvnia assets, including domestic government debt securities, more attractive, preventing household income and savings from being eroded by inflation.
More attractive hryvnia savings will help decrease demand on the FX market. This will prevent the further accumulation of imbalances, ease pressures on Ukraine’s international reserves, and will gradually resolve the issue of multiple exchange rates.
Setting market rates on domestic government debt securities will also help increase demand for these assets. At the same time, this will decrease the government’s need for monetary financing by the NBU.
The re-imposition of taxes on imports should be important step in balancing fiscal and monetary policies. On the one hand, this will secure additional revenues for the state budget, while on the other hand it will increase incentives for domestic producers and ease pressure on international reserves.
The NBU expects that a significant rise in the key policy rate, to 25%, will be sufficient to ease pressures on the FX market and stabilize inflation expectations, which in the future will lay the foundations for a monetary policy easing cycle.
This step is also required to maintain a stable exchange rate, which under the current circumstances remains an important precondition for ensuring price and financial stability.
The decision to raise the key policy rate, to 25%, from 3 June 2022 was approved by an NBU Board Decision on the key policy rate No. 262-rsh, dated 2 June 2022.
A summary of the discussion by Monetary Policy Committee members that preceded the approval of this decision will be published on 13 June 2022.
The next monetary policy meeting of the NBU Board will be held on 21 July 2022, according to the confirmed and published schedule.