The Board of the National Bank of Ukraine has decided to cut the key policy rate from 22% to 20% effective 15 September 2023. The further pullback in inflation and the NBU’s ability to ensure FX market sustainability are making it possible to continue the cycle of key policy rate cuts while maintaining the sufficient attractiveness of hryvnia savings. Such a step will support the economic recovery without posing threats to macrofinancial stability.
Although headline inflation has been declining faster than expected, core inflation is close to the NBU’s forecast
In year-on-year terms, inflation slowed to 8.6% in August. Price movements came out better than the NBU anticipated, primarily due to an increase in the supply of food products. Specifically, good harvests contributed to a decrease in the prices of cereals, flour, vegetables, and some fruits.
However, the drop in core inflation (down to 10% yoy in August) was close to the forecast the NBU made in July. The NBU’s measures to keep hryvnia assets attractive and the FX market sustainable played an important role in easing underlying price pressures. Among other things, these measures helped improve exchange-rate and inflation expectations further.
The overall downtrend in inflation is set to persist, but there is little to no potential for a rapid slowdown in price growth
On the one hand, better harvests will continue to restrain price increases in the following months. The impact of the fixing of some utility tariffs will also remain. The NBU is committed to persevere in ensuring the sustainability of the FX market to keep exchange-rate and inflation expectations in check. All of this will contribute to the further easing of inflation.
On the other hand, businesses’ costs will remain under significant pressure to rise because of war-related losses as well as higher prices for electricity and fuel. This factor can restrain the deceleration of inflation.
Although significant amounts of official financing have maintained Ukraine’s international reserves at a high level, further international support is vital amid significant budgetary needs
The inflows of official financing enable the NBU not only to offset a significant shortage of foreign currency in the market, but also to ensure a high level of international reserves. In August, they surpassed USD 40 billion.
As the war drags on, however, budgetary needs also remain high. Domestic revenues and investments are not sufficient to meet budget expenditures. International aid will therefore continue to be the primary guarantee that the budget is funded without relying on central bank financing. With this in mind, it is critically important to meet the conditions of the IMF-supported program on time and in full.
The key risk to inflation dynamics and economic development is the protracted duration and unpredictable nature and intensity of the full-scale war
The full-scale war grinds on. High uncertainty persists over when the active phase of hostilities may come to an end. Terrorist attacks by the russian army, new large-scale waves of destruction, and prolongation of hostilities continue to pose the risk of dealing more significant damage to the Ukrainian economy’s potential and triggering unpredictable inflationary shocks.
Other risks also persist. Those include:
- decreased amounts or disruptions of international aid disbursements, in part due to failure to meet the conditions of the IMF-supported program on time or in full
- the emergence of additional budget needs (to support the country’s defense capabilities, recover from terrorist attacks, and more) and substantial quasi-fiscal deficits, in the energy sector in particular
- the resumption of significant power shortages because of substantial damage sustained by energy infrastructure, which would lead to restrictions on economic activity and exports, increases in imports, and thus pressure on the FX market
- continued difficulties with exporting agricultural products, in particular if some European countries extend or expand existing trade restrictions and if the shelling of agricultural and port infrastructure continues and the Black Sea Grain Initiative is terminated.
Taking into account the balance of risks, a sharp fall in inflation, and the NBU’s ability to safeguard exchange rate stability, the NBU Board decided to cut the key policy rate, to 20%
The cycle of interest rate policy easing the NBU launched in July decreased nominal interest rates in the banking system, as was to be expected. In spite of that, the yields of hryvnia assets remained attractive, thanks to the dramatic fall in inflation and improved expectations. Even following a certain drop in August, interest rates on term hryvnia deposits and domestic government debt securities still exceed both current inflation and the inflation rate expected by households. As a result, household demand for bank deposits with maturities from three to 12 months and domestic government debt securities has continued to rise. Temporary fluctuations on the FX market did not change these trends.
Maintaining relatively high yields on hryvnia instruments is important for the continued implementation of the Strategy for Easing FX restrictions, Transition to a More Flexible Exchange Rate and Return to Inflation Targeting (the Strategy). However, given the high sensitivity of the FX market and a substantial surplus of hryvnia liquidity, more rapid cuts in the key policy rate would increase risks to exchange rate stability and the steady decline in inflation.
In view of that, starting in 15 September 2023, the NBU Board decided to cut the key policy rate by 2 pp, to 20%, which is in line with the trajectory of the July forecast. The interest rate on three-month certificates of deposit will continue to equal the key policy rate. Meanwhile, the NBU Board decreased the interest rate on overnight certificates of deposit by 2 pp, to 16%, and by 2 pp, to 22% on refinancing loans.
The controlled easing of interest rate policy will provide additional impetus to the economic recovery, without threatening macrofinancial stability during the implementation of this strategy.
What is more, the NBU will adjust the parameters of the operational design of its monetary policy. More specifically, the NBU decreased, from 70% to 35%, the share of existing household term deposit balances which are used to calculate the limits on the banks’ purchases of three-month certificates of deposit. This will further encourage the banks to compete for depositors, and to expand their term deposit portfolios. These changes will come into effect from 18 September 2023.
Looking ahead, the NBU plans to continue its key policy rate cutting cycle, while balancing the cuts against the need to maintain the attractiveness of hryvnia assets, which is key to a sustainable FX market and a steady decline in inflation
That said, given great uncertainty and high war-related risks, the NBU will act cautiously, so as to be able to safeguard macrofinancial stability in future. If expectations deteriorate, the attractiveness of hryvnia instruments declines noticeably, and risks to exchange rate sustainability increase, the NBU will adjust its decisions and key policy rate forecast accordingly.
The decision to cut the key policy rate to 20% per annum from 15 September 2023, was approved by an NBU Board Decision On the Key Policy Rate No. 323, dated 14 September 2023.
The adjustment of the operational design of the NBU’s monetary policy was approved by an NBU Board Decision No. 324 On Amendments to NBU Board Decision No. 130 dated 06 April 2023, dated 14 September 2023. This decision comes into effect from 18 September 2023.
A summary of the discussion by Monetary Policy Committee members that preceded the approval of this decision will be published on 25 September 2023.
The next monetary policy meeting of the NBU Board will be held on 26 October 2023, according to the confirmed and published schedule.