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National Bank of Ukraine Cuts the Key Policy Rate and Streamlines the Operational Framework of Monetary policy

The Board of the National Bank of Ukraine has decided to cut the key policy rate to 19%, effective from 22 April 2016. This was made possible due to a further alleviation of risks to price stability. At the same time, the NBU has streamlined the operational framework of monetary policy. This move has been prompted by the need to enhance the effectiveness of monetary instruments to strengthen the NBU’s capacity to implement monetary policy in the context of inflation targeting.

In March 2016, as expected, the disinflation trend continued, with annual headline inflation moderating to 20.9%. Core inflation continued to ease to 15.0% y-o-y. Overall, headline inflation rose by 1.5% q-o-q, underperforming the NBU’s inflation forecast.

Inflationary pressures have been dampened due to the authorities’ commitment to prudent monetary and fiscal policy, subdued domestic demand, and stabilization of inflation expectations.

The temporary surge in exchange rate volatility observed in January-February 2016 had a relatively limited impact on the inflation rate because factors exerting pressure on the exchange rate also contributed to an increased supply of foods, thus bringing domestic prices down. The NBU’s measures in the FX market were aimed at smoothing excessive exchange rate fluctuations, which also helped contain inflation pressures. In March, the FX market stabilized due to a rebound in demand and prices for Ukrainian export commodities, which led to the strengthening of the hryvnia exchange rate.

The NBU has kept its headline inflation projection unchanged at 12% by the end of 2016 and 8% by the end of 2017, which is consistent with its inflation objectives.

Most factors causing inflation to deviate from the projected path in the first quarter are believed to be short-lived, with a high likelihood of their reversal over the next quarters. The disinflation trend will be supported by the authorities’ commitment to prudent fiscal policy and the pass-through of the exchange rate depreciation observed in March-April 2016.

The NBU has kept its 2016 outlook for economic activity unchanged. Real GDP is expected to rise by 1.1% in 2016 and by 3% in 2017. In particular, the NBU has also kept its forecast for the current account deficit unchanged (USD 2.3 billion or 2.7% of GDP in 2016 and USD 1.8 billion or 1.9% of GDP in 2017).

Inflation pressures and downside risks to inflation projections, which prevented the NBU from easing monetary policy in the first quarter of 2016, have significantly abated since the previous NBU Board's monetary policy meeting. In particular, with the formation of a new government, political tensions have eased. External risks have also abated due to the resumption of transit of Ukrainian goods through the territory of the Russian Federation and a gradual recovery in prices for key Ukrainian export commodities. However, delays with the resumption of cooperation with the International Monetary Fund remain the major downside risk to inflation projections. The new Government's commitment to proceed with urgent reforms is essential to getting the program back on track.

Should risks to price stability abate further, and if Ukraine secures the successful completion of the second review under the Extended Fund Facility Arrangement, the NBU may move ahead with monetary easing.

Additionally, the NBU Board has decided to streamline the operational framework of monetary policy. From now on, the NBU will set the discount rate at the level of the key policy interest rate. In the current situation, where the banking system has surplus liquidity, the rate on 14-day certificate of deposits serves as the key policy rate. The 14-day deposit-taking operations, which account for the largest share of all the certificates of deposit (CD) placed with banks, have a key impact on money market conditions.

Identifying a single policy rate through the convergence of the discount rate and the 14-day CD interest rate (currently set at 19%) will improve the first link of the chain of cause-and-effect of the transmission mechanism of monetary policy and therefore increase its effectiveness to steer short-term interbank market interest rates. Going forward, changes in the key policy rate as the key reference interest rate and policy-induced changes in interest rates will be translated into changes in interest rates on other financial assets (in particular, government securities) and retail interest rates on loans and deposits. The clarity and predictability of key policy rate adjustments will contribute to increasing the effectiveness of the transmission mechanism of monetary policy through which the NBU steers inflation towards inflation objectives.

As part of the efforts to redesign the operational framework of monetary policy, the NBU has streamlined the procedures and liquidity management instruments.

First, the NBU has narrowed the corridor of interest rates on standing facilities around the key policy rate. The interest-rate corridor is symmetric around the key policy rate. The top of the interest rate corridor is the interest rate on standing overnight refinance facilities, which is 200 basis points above the NBU key policy rate. The bottom of the interest rate corridor is the interest rates on the overnight deposit facility, which is 200 basis points below the NBU key policy rate.

Second, the NBU has ceased the practice of holding CD placement tenders at maturities of less than 14 days. On one hand, this move will boost the development of the interbank credit market. On the other hand, the key policy rate will convey a clearer signal of changes in the stance of monetary policy.

Third, the NBU will conduct all liquidity-providing operations at a single interest rate equal to the rate on overnight loans.

And fourth, the NBU has disallowed the early repayment of NBU CDs.

The NBU Board believes that the current economic situation and the balance of risks enable the regulator to resume easing of FX controls following the resumption of cooperation with the IMF.

 The decision on the key policy rate is approved by NBU Board Resolution No. 278, dated 21 April 2016, On Money Market Regulation. The decision on redesigning the operational framework of monetary policy is approved by NBU Board Resolution No. 277 dated 21 April 2016, On Interest Rate Policy.

A detailed macroeconomic forecast will be published in the Inflation Report on 25 April 2016.

The next meeting of the Board of the National Bank of Ukraine on monetary policy issues will be held on 26 May 2016, as scheduled.

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