The Board of the National Bank of Ukraine has decided to cut the key policy rate from 25% to 22% effective 28 July 2023. Rapid disinflation and sustained FX market conditions enabled the central bank to start the cycle of key policy rate cuts. Taking into account an improvement in inflation expectations and projected further disinflation, the current and forecast rate cuts conform to maintaining the attractiveness of hryvnia savings. This is an important element of ensuring exchange rate sustainability amid the easing of FX restrictions and shifting to a more flexible exchange rate. At the same time, reducing the key policy rate against the backdrop of sustained macrofinancial stability will support economic recovery.
Inflation declined markedly in H1, including thanks to the NBU’s measures
Consumer inflation decelerated to 12.8% yoy in June, down from more than 26% yoy at the start of the year, which exceeded the NBU’s expectations. In addition to the base effect, supply factors played an important role – in particular, the saturation of food and fuel markets and a decrease in global energy prices. Measures taken by the NBU – in particular, an increase in reserve requirements and a change in the operational design of monetary policy – also had a significant impact on price movements. These steps helped make hryvnia assets more attractive, including thanks to a larger increase in bank interest rates on term deposits and the strengthening of the cash exchange rate of the hryvnia. The NBU’s AML/CFT and currency supervision measures also contributed to FX market sustainability. The exchange rate factor eventually drove a decline in inflation both directly, through prices of goods, and indirectly, through an improvement in expectations. The latter was also supported by the absence of monetary financing of the budget this year.
The NBU has improved the inflation forecast for 2023 and the next years. At the same time, further disinflation is expected to be slower than in H1
Having considered the favorable dynamics of H1, the NBU revised its 2023 inflation forecast significantly upward, from 14.8% to 10.6%. The growth in prices will slow due to a gradual decline in global inflation and monetary conditions remaining tight in Ukraine. The NBU will safeguard sustainability of the FX market and keep hryvnia assets attractive enough, which will restrain price pressures. Tariffs being frozen for the majority of utility services will play an important role. At the same time, further disinflation will be slower than in the previous months. This is driven by the waning of the base effect, returning to the pre-war level of the fuel tax, and the increase in electricity prices for household consumers in June. Moreover, russia’s terrorist attacks in the south of Ukraine – particularly, the destruction of Kakhovka Hydro-Power Plant – will have an impact on price dynamics.
The disinflation trend will continue in the coming years. Lower security risks will allow restoring optimal logistical routes and increasing industrial production and crop harvests. Furthermore, this will enable a resumption of investment inflows to Ukraine. A further decline in global prices, in particular energy prices, will also contribute to the slowdown in inflation. The said factors outweigh the pro-inflationary impact of an increase in domestic demand, a rise in wages, and a correction of some utility tariffs in the post-war period. Therefore, the NBU expects inflation to decline to 8.5% in 2024 and to 6% in 2025.
The economy has proven to be resilient to new challenges of the war and is to grow by 2.9% this year
Against the backdrop of the stable functioning of the energy system and macrofinancial sustainability, an increase in domestic demand contributed to the further revival of economic activity. On the other hand, business activity has been restrained by constant missile attacks, blocking of the grain corridor, and more damage inflicted on infrastructure. In addition, trade barriers imposed on Ukrainian agricultural products by some countries had an adverse effect on business. These factors drove a decrease in exports from Ukraine in Q2 and will be a drag on the country’s economic recovery going forward. At the same time, actual results of Q1 turned out to be better than envisaged in the previous macroeconomic forecast. Economic activity continued to pick up in Q2, in both the manufacturing and services sectors. Taking this into account, the NBU revised its real GDP growth forecast for 2023 moderately upward, from 2.0% to 2.9%.
Further on, economic growth will accelerate, based on the NBU’s forecast assumption about a decline in security risks in mid-2024. Exports will recover more actively after maritime logistics is restored and attacks on infrastructure cease. The gradual return of migrants will spur consumer demand, and investment will pick up during the country’s reconstruction. The loose fiscal policy will remain important for stimulating the economy: the budget deficit will remain significant due to the need to support the defense capability and economic recovery. Taking this into consideration, the NBU forecasts real GDP growth at 3.5% in 2024 and 6.8% in 2025.
Regular inflows of official financing helped bring international reserves to an all-time high. Continued international support remains crucial
Since the start of the year, Ukraine has received almost USD 27 billion in loans and grants from international partners. This was much more than the amount of the NBU’s sales of foreign currency to balance the FX market. Thanks to regular inflows of external assistance, Ukraine’s international reserves reached an all-time high of USD 39 billion as of the end of June. Thanks to the external support, the government was able to cover the wide budget deficit without resorting to monetary financing.
International assistance is expected to reach USD 42 billion as of the end of this year. These inflows will restrain an increase in the current account deficit, which will account for 6.5% of GDP this year, and will be more than enough to cover the deficit. International support will remain very important for maintaining macrofinancial stability in the coming years. Considering the still high expenditures on defense, financing the budget deficit in 2024 will require no less than USD 37 billion. Even after active hostilities are over, the need for external financing will remain high due to limited export potential and significant import needs to support the country’s post-war recovery. Ukraine needs to continue its successful cooperation with the IMF and other international partners.
The key risk to inflation dynamics and economic development is still the longer duration and the unpredictable nature and intensity of the full-scale war
The NBU’s new forecast is based on the assumption that security risks will decline considerably in mid-2024. A full-scale war that lasts longer than expected could result in the additional losses of economic growth, in particular through greater damage and increased migration. This could also adversely affect price movements, due to mainly, higher pressures on exchange rate and inflation expectations.
There are other significant risks. These include:
- international aid arriving in decreased amounts or on a less regular basis
- the resumption of significant power shortages because of the substantial damage sustained by energy infrastructure, which would lead to restrictions on economic activity and exports, stronger needs for imports and, consequently, to higher pressures on the FX market
- new large-scale terrorist attacks, which would limit export logistics and the country’s economic potential in general
- the emergence of additional budget needs (to support the country’s defense capability, recover from terrorist attacks and so on) and substantial quasi-fiscal deficits, including in the energy sector and
- the ongoing difficulties with exporting agricultural products, in particular if some European countries extend or expand existing trade restrictions.
The new macroeconomic forecast is based on the conservative assumption that the grain corridor will remain non-operational. The resumption of its operation or the expansion of alternative routes will help expand export opportunities, facilitating more robust economic recovery.
The implementation of large-scale projects for Ukraine’s recovery could speed up economic growth. At the same time, a faster-than-currently-expected decline in security risks could have the most significant positive impact on economic development.
In view of the faster-than-expected decline in inflation, long-lasting stable conditions on the FX market, a high level of international reserves, as well as the effectiveness of previous measures to boost the attractiveness of hryvnia assets, the NBU Board decided to start a key police rate decrease cycle earlier than the April forecast envisaged.
The NBU’s previous measures significantly tightened competition among the banks for hryvnia term deposits. In summer, the banks continued to raise their interest rates on hryvnia deposits. At the same time, a rapid decline in inflation and a stable FX market encouraged depositors to refocus on hryvnia term deposits even more. In addition, the NBU’s ability to safeguard exchange rate sustainability increased, thanks to international assistance, which is contributing to depositors’ optimistic expectations.
Favorable trends have provided the NBU with room to launch a monetary policy easing cycle more quickly. The NBU Board decided to cut the key policy rate by 3 pp, to 22%. The NBU Board also decreased the interest rate on overnight certificates of deposit by 2 pp, to 18%, and by 3 pp, to 24%, on refinancing loans. The interest rate on three-month certificates of deposit will continue to equal the key policy rate.
On the one hand, taking into account improved inflation expectations and the forecast that inflation would decline further, the current and projected decrease in interest rates on NBU operations will maintain the attractiveness of hryvnia savings. This is an important element for ensuring exchange rate sustainability when FX restrictions are eased and the NBU makes the exchange rate more flexible. On the other hand, the cut in NBU interest rates will support economic recovery on the back of persisting macrofinancial stability.
The NBU will continue to cut its key policy rate, provided the FX market remains stable and inflation declines over the forecast horizon. When easing FX restrictions and transitioning to a more flexible exchange rate regime, the NBU will take into account the need to maintain the high attractiveness of hryvnia assets
The NBU’s revised macroeconomic forecast envisages further key policy rate cuts. The key policy rate will be cut gradually so as not to undermine the trend towards a steady decline in inflation or FX market sustainability. The main prerequisite for this is maintaining the attractiveness of hryvnia assets at a sufficiently high level, which would protect hryvnia savings from being eroded away by inflation. When easing FX restrictions and transitioning to a more flexible exchange rate regime, it is crucial to maintain high confidence in the hryvnia.
That said, the NBU is not compelled to stick to its key policy rate forecast. Given high uncertainty, any further decisions and revisions of the NBU’s key policy rate forecasts will largely depend on whether or not the forecast’s assumptions materialize, as well as on the trends of key macroeconomic and financial indicators.
The decision to cut the key policy rate to 22% per annum from 28 July 2023, was approved by an NBU Board Decision No. 258 On the Key Policy Rate, dated 27 July 2023, and the one to change the interest rates on standing facilities - by NBU Board Decision No. 257 On Setting Rates on Standing Facilities of the NBU, dated 27 July 2023
A summary of the discussion by Monetary Policy Committee members that preceded the approval of this decision will be published on 7 August 2023.
The next monetary policy meeting of the NBU Board will be held on 14 September 2023, according to the confirmed and published schedule.