Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 1 June 2022

Date of the meeting: 1 June 2022.
Attendees: all ten members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Kyrylo Shevchenko, NBU Governor
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director, Financial Stability Department
• Volodymyr Lepushynskyi, Director, Monetary Policy and Economic Analysis Department
• Oleksii Lupin, Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department. 

During the meeting, the MPC members discussed changes in the consumer and economic behavior of households and businesses, and risks to macrofinancial stability, including increased pressure on the exchange rate and international reserves. A special focus was placed on improving the NBU’s ability to ensure exchange rate stability and curb inflation during the war.

The MPC members concluded that maintaining exchange rate stability under current conditions would guarantee price and financial stability. Exchange rate stability remains the sole nominal anchor for expectations, a mechanism for subsidizing critical imports, and thus the primary tool for curbing inflationary pressures and maintaining the stability of the financial system. Specifically, with the hryvnia exchange rate for critical imports having been fixed, inflation remains controlled.

The economy is not yet ready to return to floating exchange rates. Appropriate macroeconomic preconditions should first emerge. In particular, the FX market’s ability to self-balance must increase. Otherwise, a correction in the official exchange rate will only trigger unnecessary shocks for economic agents, worsen expectations, and change the domestic price level by a respective percentage, but pressure on the hryvnia and international reserves will persist. This is in part due to the gradual replacement of the initial psychological shock by a decision-making pattern of households, importers, and exporters that is driven by economic incentives.

As inflation expectations have gradually worsened, the real yield on hryvnia instruments, especially deposits and domestic government debt securities, has become increasingly negative. This encourages economic agents to look for ways to protect their savings, including by buying foreign currency and imported goods. As a result, the dollarization of the economy and the withdrawal of savings from the financial system are intensifying. The growth in imports, including those unrelated to priority needs, is also fueled by cuts to taxes and import tariffs. Other unintended effects of the tax cuts include the deteriorating competitiveness of domestic producers, a widening state budget deficit, and a growing need for direct monetary financing of prioritized government spending. Monetization of public debt by the NBU is not strengthening confidence in the hryvnia and the central bank.

Over the past month, the problem of multiple exchange rates has intensified, which is adversely affecting the behavioral aspects of various economic agents, primarily in the IT segment, and other exporters, and speeding up the shadowization of the economy as individuals and companies evade administrative constraints. The increase in the supply of foreign currency remains constrained, despite the gradual expansion of export opportunities as alternative logistics routes emerge.

To meet a growing FX shortage, the NBU in May conducted net FX sales of USD 3.4 billion, up significantly from USD 1.8 billion in March and USD 2.2 billion April. Although the current level of international reserves is sufficient to maintain a fixed exchange rate, this margin of safety cannot last forever, especially if the war drags on into the long run. International financial aid inflows have been erratic. They are falling short of meeting Ukraine’s wartime needs.

Under such conditions, the NBU should return to an active interest rate policy and restore the appeal of hryvnia assets as instruments to invest and save. Coupled with measures to spur competition in the FX market’s cash segment and reduce unproductive capital outflows from Ukraine, this will help balance FX supply and demand, reduce the need for large-scale interventions by the NBU, and ease the risks of a currency crisis and a loss of control over inflation.

The MPC members also discussed the potential side effects of the key policy rate hike on various groups of economic agents. If a corresponding increase in the interest rates on domestic government debt securities were to take place, the cost of servicing public debt would rise. The servicing of government lending support programs would also be more expensive. However, this effect on budget expenditures in 2022 is estimated to be small (with the bulk of it falling on 2023) and can be offset by large volumes of market borrowing.

The discussants paid special attention to the impact of the key policy rate hike on banks’ balance sheets due to the potential revaluation of securities in their portfolios, an increase in repayments on refinancing loans, and a rise in banks’ income from certificates of deposit. The effect of such a securities revaluation will be stretched out in time, and the banking system’s structural liquidity surplus will make banks benefit, rather than suffer, from the key policy rate increase.

In current conditions, the higher key policy rate will have a limited impact on lending. First, the cost of loans depends primarily on the actual cost of bank funding, which today remains negligible and will not change quickly, as the cost of previously raised deposits is low. Second, most new loans are currently issued under government programs, and so the preferential terms for such borrowers will continue to be in effect. Third, since the war broke out, banks have raised interest rates on loans to cover the higher risks of loan delinquency. Going forward, banks will raise loan interest rates carefully to mitigate the risk of losing customers and having loan servicing deteriorate in quality.

The short-term impact of higher interest rates on public finances and lending will therefore be moderate, but it will help maintain overall macrofinancial stability in wartime and lay the groundwork for a sustainable economic recovery.

Most MPC members called for a decisive increase in the key policy rate in June: seven of them said the rate should rise to 25%, while two argued for 24%.

These discussants agreed that to make hryvnia assets significantly more attractive, interest rates on them should rise to 24%–25%, a level that exceeds the medium-term inflation expectations of economic agents. This will motivate depositors and investors to earn high returns from hryvnia instruments before the NBU launches a cycle of key policy rate cuts.

In contrast, a small increase in the key policy rate is unlikely to change the situation.  Market participants will expect further rate increases and will mainly delay their investment and savings decisions until they are convinced that the yields on hryvnia instruments have reached maximum levels.

In addition, with elevated uncertainty, administrative restrictions on capital movements, high liquidity surpluses in the banking system, and the lack of broad alternatives for banks and their depositors to invest in, the effectiveness of the monetary transmission mechanism has declined significantly. To generate the desired response in the form of faster and more significant increases in rates on domestic government debt securities and deposits, the economy therefore needs to receive a one-off impulse from a key policy rate hike to 24%–25%. Such a step should relieve pressure on the FX market and strengthen the NBU’s capability to ensure exchange rate stability and curb inflation during the war.

A sharp increase in the key policy rate is currently one of the few tools in the central bank’s arsenal that can effectively relieve pressure on the FX market, one of the discussants emphasized. Warning signals for macrofinancial stability are coming from the trends observed in the banking system, which is gradually losing its power to raise market-based funding through term deposits, while the auctions held by the Ministry of Finance to issue domestic government debt securities are also ineffective, this MPC member said. Further preservation of nonmarket rates on hryvnia instruments will lead to a rapid depletion of international reserves and a dollarization of the economy. All of this poses serious inflation and exchange rate risks that, if allowed to materialize, will undermine economic recovery.

According to another MPC member, an alternative to this solution is to further tighten the FX regulation, but additional administrative measures may provoke a backlash from businesses and households and exacerbate the multiplicity of exchange rates and are unlikely to take pressure off international reserves and the exchange rate.

Delays in raising the key policy rate will lead to hyperinflation, causing losses for both businesses and households, one of the discussants argued.  The banking system currently holds about half a trillion hryvnias in household savings. If we take no measures to protect this money from depreciation, it will eventually find its way into the FX market, and banks will face an avalanche of deposit outflows. The rapid growth in imports in May highlights the magnitude of this risk, as does the surge in the demand for cash foreign currency. The NBU has recently been able to meet this demand through FX interventions, but international reserves are declining.

Data from transactions abroad with Ukrainian-issued payment cards also points to the need to make hryvnia assets more appealing, another MPC member said. A large portion of debit transactions ‘from card accounts have been to convert cash hryvnias into foreign currency. This puts international reserves under significant pressure.

The situation may follow two scenarios, another discussant suggested. The first is a Latin American scenario in which the pursuit of a cheap money approach will fuel repeated cycles of depreciation and inflation as the government struggles to offset their effects on the population by raising nominal social standards. This will lead to a plunge in real incomes and deplorable consequences for the economy. Alternatively, the second scenario involves a switch to an expensive-money policy of the kind pursued by the Bank of Israel in the 1990s. This will improve the appeal of hryvnia assets, ease pressure on the FX market and international reserves, maintain confidence in the hryvnia and the financial system, and therefore increase the NBU’s power to ensure price and exchange rate stability. Going forward, such an approach will lay the basis for the return to the floating exchange rate regime, the removal of FX restrictions, and the solution of the problem of multiple exchange rates.

One MPC member called for a more moderate increase in the key policy rate in June, to 20%.

This MPC member agreed that the optimal solution in the current conditions was to give the key policy rate a one-time boost and subsequently roll it back as the situation stabilizes. Taking into account the monetary transmission lag, however, a 10 pp hike in the key policy rate would be sufficient to cover inflation risks over the horizon of the key policy rate impact, this MPC member said.

Inflation expectations may at this point be slightly overrated due to the psychological tendency to project the events of the first three months of the war onto further economic developments, this MPC member noted. The initial macroeconomic shock from the war, which resulted in logistical hurdles, shortages of certain goods, and other problems, is almost over, and most of the increase in inflation it entailed has already occurred. Going forward, the economy will adjust. Therefore, even though inflation is high, there is a significant probability that it will decelerate next year, given that the initial shocks that have triggered inflation this year can largely die down. Specifically, the impact of key pro-inflationary factors may actually weaken by the end of this year as logistics are rerouted and fuel shortages eased.

Western partners are expected to provide large-scale military and financial assistance in the coming months, which will have an additional stabilizing effect on the FX market and public finances, this MPC member added. Successful operations by the Ukrainian Army will continue to contribute not only to the general improvement of expectations, but also to the equalization of price dynamics in different regions and thus to slower inflation, given that price growth in the occupied and war-torn areas has objectively been more rapid. Slowed by these effects, inflation in 2023 may go back to low levels.

Most MPC members expect that the key policy rate raise to 25% is the last in this cycle of hikes, and that the NBU will be able to go back to an accommodative monetary policy as the military and economic situation improves.

In the long run, we should be prepared for a scenario in which Ukraine receives significant capital inflows under international aid and economic recovery programs, several discussants pointed out. Such an influx of capital will strengthen the real exchange rate and blunt the competitive edge of domestic producers. To prevent these trends, the NBU will have to cut the key policy rate rather quickly.

Meanwhile, several other members of the MPC emphasized that uncertainty remained high, and that the NBU should therefore be ready to use all available tools to ensure price and financial stability, in particular by further increasing the key policy rate (as needed).

The NBU’s further actions will primarily depend on how the situation at the front lines unfolds, these MPC members argued. The liberation of the occupied regions will certainly improve expectations, but as long as intense fighting rages on, the anchoring of expectations remains rather tentative. If the hostilities continue for a long time, inflation risks will increase significantly. Destroyed capacities, disrupted supply chains, and the loss of crops from the occupied south will have a strong impact on price dynamics. In addition, the volume and schedule of international aid supplies are uncertain. After the active phase of the war is over, we should also expect the return of the majority of displaced people, and with it an increase in demand that will not immediately be met by supply. This will leave the central bank with the need to make difficult decisions.

If the monetary transmission of the key policy rate hike to market returns proves insufficient for some reason, the NBU should take additional measures to strengthen this mechanism, keep the exchange rate stable, and safeguard international reserves, the MPC members agreed.