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NBU Makes No Change to Its Inflation Forecast 2018–2020

NBU Makes No Change to Its Inflation Forecast 2018–2020

The National Bank of Ukraine has left its inflation forecast for year-end 2018 unchanged at 8.9% and revised the core inflation forecast downwards to 7.1%. A faster-than-expected disinflation in May–June 2018 will be neutralized in the second half-year due to stronger inflation factors, which will persist in the three quarters of next year. Therefore, the NBU will be able to bring inflation back to the target range only in Q4 2019. More details can be found in the quarterly Inflation Report of July 2018.

In H2 2018 and 2019, inflation will be exposed to a number of factors. This includes a greater-than-expected increase in administered prices at the end of 2018 as domestic gas prices move closer to the import parity price.

At the same time, other inflation factors will be more fundamental.

First, the economy will face higher-than-expected domestic demand, among other things, due to wage growth and greater remittances from labor migrants.

Second, investor interest in Ukrainian sovereign debt will decline as a result of a global trend for exiting developing markets’ assets and postponed financing under the IMF cooperation program.

In addition, inflation expectations will exceed the NBU’s inflation targets.

The tight monetary policy will offset the effect of these factors and will be among the key contributors to bringing inflation to the target range in Q4 2019. This will also be supported by a conservative fiscal policy due to budget constraints caused by large repayments of public debt, moderate imported inflation amid relatively low exchange rate volatility, and decreased pressure from administered prices.

The inflation forecast for the coming years also remains unchanged: consumer price inflation will reach 5.8% at year-end 2019 and decelerate to 5.0% in 2020, settling at the midpoint of the target range (5.0% ± 1 pp).

Apart from revised macroeconomic forecasts, the July Inflation Report also deals with the following specific topics:

  • Consequences of deteriorated financial conditions for developing markets: why some countries turned out to be more vulnerable than others

Following a period during which developing markets enjoyed favorable global financial market conditions due to low interest rates and ample liquidity, financial conditions deteriorated markedly in Q2 2018.

Capital inflows to developing countries dried up in mid-April, while domestic currencies of the majority of these countries depreciated against the US dollar. All the same, these counties are generally better prepared for a worsening of external conditions than they were in previous periods. This is a result of the prudent macroeconomic policies being conducted by most developing countries, including monetary policies based on inflation targeting, which, among other things, implies a flexible exchange rate regime, the enhancement of the central bank’s institutional independence, the resilience of the financial system, and the absence of fiscal dominance.

However, some countries, such as Argentina and Turkey, have proved to be more vulnerable to the deteriorating global financial conditions. The current financial turmoils in Argentina and Turkey show that floating exchange rates alone do not necessarily minimize the adverse effects of external shocks, while delays in reform implementation leave a country vulnerable to changes in investor sentiment. 

The insufficient independence of a central bank in its monetary policy decisions leads to an accumulation of external and internal imbalances and reduces the country’s credibility in the eyes of investors. Therefore, countries that are sensitive to a deterioration in global financial conditions should maintain a sufficient level of credibility among foreign investors by conducting a prudent fiscal policy and a rather tight monetary policy and by carrying out structural reforms aimed at establishing a sound macroeconomic environment.

  • Development of the green energy sector in Ukraine

Increased investments in green energy and the broadening of its role are a global trend. In Ukraine, the green energy sector started to develop in 2009, when the Law on Promoting the Use of Alternative Energy Sources was adopted. The law introduced a special tariff, which was set above the average market price of electricity in Ukraine and the corresponding tariffs in some European countries.

However, despite the rapid development seen in the last few years, the role of green energy in Ukraine’s energy system is still minor: green energy accounted for about 6% of total energy production in 2016–2017 and 1.5% of total electricity generation.

While the current cost of green energy is high – payments for electricity that is generated from renewable energy sources accounted for 7.5% of total electricity payments in 2017 – the cost is expected to decline every year due to advances in technology and the expected introduction of auctions to set tariffs for renewable energy.

However, along with a number of social and economic benefits of development of renewable energy generation, the profitability of renewable energy companies is very susceptible to regulatory influence, which poses high risks to the further development of this sector.

  • Youth unemployment in Ukraine

Even though Ukraine’s economy has recovered from the 2014–2015 crisis, unemployment in Ukraine is still high (9.3% in 2016 and 9.5% in 2017). Protracted unemployment has negative effects on both individuals and the entire economy due to the loss of human capital, the contraction of private consumption, a decline in future wages, and multiple social implications.

These problems are most typical of youth unemployment, as young people are one of the labor market’s most vulnerable population groups, according to researchers. The high unemployment in the 15–24 age demographic is driven by their lack of the kind of professional skills and expertise that employers require.

In Ukraine, the majority of young people aged 15–24 are economically inactive (nearly 65.6% in 2017), as most of them go to school at that age (high-school and university students represented close to 85% of the economically inactive population aged 15–24). Meanwhile, according to SSSU data, in 2017, unemployed youth between 15 and 24 years of age accounted for over 15% of Ukraine’s unemployed population, and 18.9% of the economically active population of the same age.

Potential measures to tackle youth unemployment include: optimizing the operation of employment offices, in particular through cooperation with private businesses; elaborating educational programs in order to bring knowledge and skills that young people obtain during their studies closer to employer requirements; broadening internship programs for pre-graduates, and so on.

  • Neutral real rate of interest in a small open economy: application to Ukraine

Determining the neutral real (equilibrium) rate of interest – the level of the real, short-term risk-free rate – is important for analyzing monetary conditions under the inflation targeting regime.

The neutral real interest rate is determined by the process of interaction between the demand for investment and the supply of savings. What distinguishes a small open economy like Ukraine’s is the fact that the supply of savings is determined outside of the economy, on the global markets.

This makes the cost of resources very dependent on external conditions. At the same time, the key internal factors are the sovereign risk premium (which depends on fiscal and external resilience, political instability, the effectiveness of the banking sector, and demographic changes) and anticipated changes in the real exchange rate.

Calculating the neutral rate of interest is a useful tool for policy analysis. For example, it shows that in the past (before the introduction of the inflation targeting regime) short-term interest rates had been below the neutral rate for a long period of time. Such a stance of monetary policy caused foreign exchange crises and inflation spikes in Ukraine.

Since the beginning of 2016, the NBU has been maintaining its real key policy rate above the neutral rate of interest, which supports disinflation processes, in line with its declared inflation-targeting regime. Over the medium term, the NBU’s key policy rate should remain at a level sufficiently above the neutral interest rate in order to ensure disinflation and stabilize inflation expectations at a level close to the target.

The Inflation Report reflects the opinion of the National Bank of Ukraine as to the current and future economic state of Ukraine, with a focus on inflationary developments, which form the basis of monetary policy decision-making. The National Bank of Ukraine has been publishing its Inflation Report on a quarterly basis since April 2015.

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