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NBU Keeps 2019 – 2021 Inflation Forecast Unchanged and Improves Growth Forecast

NBU Keeps 2019 – 2021 Inflation Forecast Unchanged and Improves Growth Forecast

Inflation will decline to 6.3% by the end of this year, reaching the target range of 5% ± 1 pp in early 2020. It is expected to meet its medium-term target of 5% at the end of 2020. Meanwhile, the Ukrainian economy will grow by 3.5%-4% in 2019 – 2021. For details, see the NBU’s quarterly Inflation Report dated October 2019.

The NBU has left the inflation forecast unchanged from the projection it made in July. Rather tight monetary conditions will continue to contribute to the decrease in inflation. Other contributors to slower price growth will be a prudent fiscal policy, relatively low energy prices on the global markets, and higher productivity in the Ukrainian agricultural sector.

Core inflation will slow to 3.7%–3.8%, thanks to a consistent monetary policy. Raw food prices are also expected to grow moderately (by 3%–4%), provided there are no significant supply shocks. Administered prices will grow at a rather fast pace (about 10%), due to excise taxes on tobacco and alcohol products being brought to European levels.

The NBU has revised upward its economic growth forecast for 2019 – 2021. Under the base scenario, economic growth in Ukraine will hit 3.5% in 2019 and 2020 in each year (3.0% and 3.2% respectively according to July’s forecast), speeding up to 4.0% in 2021 (3.7% according to July’s forecast).

Another record harvest of grain, sustained domestic demand, and lower energy prices will compensate for the slower growth in the global economy and trade, as well as for the less favorable price environment faced by Ukrainian exporters.

As in July, the NBU’s forecast scenario envisages that the key policy rate will be cut further, to 8% as of the end of 2021, provided that inflation steadily declines to its 5% target. However, the current forecast is based on a slightly lower trajectory of the key policy rate over the next few quarters compared to July’s forecast, due to rate being cut more significantly in October.

In addition to the updated macroeconomic outlook, the October 2019 Inflation Report features a number of special topics, including the following:

An alternative scenario of the macroeconomic forecast: the speeding up of reforms

Although the Ukrainian economy is on the path to steady recovery from the 2014 – 2015 crisis, its 3% growth is not sufficient to catch up with neighboring European countries. Economic growth could be sped up by implementing the key internal reforms envisaged in the memorandum of understanding signed by the Ukrainian government and the NBU, as well as judiciary reform.

The experience of other countries also shows that investment plays a key role in accelerating economic growth. To achieve a breakthrough annual investment growth must, on average, exceed 20%, while the percentage of investment must make up 25%-30% of GDP. This usually requires structural reform, although accompanying favorable external conditions are also a significant factor.

The NBU estimates that the impact on inflation will, on average, be neutral under the accelerated growth scenario – inflation will remain within its target range of 5% +/-1 pp because a stronger hryvnia will compensate for robust consumer and investment demand. Under this scenario, the key policy rate could be cut below the expected 8%, on the back of decreased risks associated with investment in Ukrainian assets and a faster strengthening of the real exchange rate.

This scenario also carries certain risks: the strengthening of the hryvnia may not be able to offset inflationary pressures from overheated consumer demand; insufficient supply on the labor market could also increase inflationary pressures; vulnerability to capital flows would rise.

Assumption about the volumes of Russian gas transit through Ukraine in 2020 – 2021

Russia is actively putting bypassing gas pipelines into operation. The total throughput of these pipelines is sufficient to fully replace Ukrainian gas pipelines in the coming years. The ten-year gas transit agreement entered into between Ukraine and Russia expires in late 2019. A new agreement is still being negotiated. It is currently unclear what term any new agreement will have, and what the transit volumes will be.

Gas transit earns Ukraine about USD 3 billion a year. A halt in gas transit will not only result in a direct loss of FX earnings, but will also create risks to the operation of related sectors of the economy, and to Ukraine meeting its own gas needs.

According to the NBU’s assumption that underlies its baseline scenario of the macroeconomic forecast, transit volumes could drop from about 90 billion cubic meters in 2019 to 50 billion cubic meters in 2020 and to 30 billion cubic meters from 2021 onwards. The direct losses of the economy compared to 2019 transit volumes would hit 0.6% of GDP in 2020 and 0.9% of GDP from 2021 onwards. There are, however, other alternative scenarios that envisage both higher and lower transit volumes.

Consumer confidence in Ukraine

In September 2019, consumer confidence reached a 12-year high, supported by rapid wage growth and the improved macroeconomic environment. The consumer optimism was traditionally boosted by expectations of positive changes in the country after the elections.

Higher household income and strong consumer confidence determine households’ consumer behavior. In turn, more consumption by households is one of the GDP growth drivers.

Reasons for the slower growth in wages

Rapid wage growth seen in Ukraine over the past years was driven by several factors. The legislative change in the minimum wage was the main factor. Apart from its direct impact on remuneration of employees with the lowest wages, the minimum wage also spurs growth in wages of better-paid employees. Inflation was the next important factor. Its influence increased markedly after the last crisis of 2014–2015. However, its role has been declining in the recent years as inflationary pressures are weakening on the back of the tight monetary policy and prudent fiscal policy. Finally, another important factor was the lack of labor force caused by increased migration following the economic crisis of 2014–2015.

However, unlike in the EU and the US, Ukrainian wages show little sensitivity to changes in labor productivity. That poses a problem for the economy, feeding into inflationary pressures. Noninflationary growth in wages and their convergence with the levels of the neighboring European countries can be attained by implementing the key reforms, in particular the labor reform and the reform of the education system.

Pricing on the European natural gas market and the link to oil prices

Pricing mechanisms based on the so-called Groningen model have dominated gas markets of continental Europe for more than a half of a century. Originally, the model pegged contractual prices of natural gas to prices of other energy resources: mazut and diesel fuel, which were later joined by crude oil. This peg synchronized the price trends of oil and gas.

Today, however, this correlation between oil and gas prices has weakened. The shale oil revolution, growing demand for environmentally safe fuels, a major increase in US gas production, and other factors determine the large global gas market, on which prices are less dependent on the oil price trend.

The Inflation Report reflects the NBU’s perspective on the current and future state of Ukraine's economy, with an emphasis on inflation, which is the basis of monetary policy decisions. The NBU has published the quarterly Inflation Report since April 2015.

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