Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 12 June 2024

Meeting date: 12 June 2024.

Attendees: all 11 members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Andriy Pyshnyy, Governor of the National Bank of Ukraine 
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Dmytro Oliinyk, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director, Financial Stability Department
• Volodymyr Lepushynskyi, Director, Monetary Policy and Economic Analysis Department
• Oleksandr Arseniuk, Acting Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department.

MPC members discussed the scope to further ease monetary conditions given subdued price developments, continued improvement in inflation expectations, and the balance of risks to inflation’s future trajectory

The MPC members noted that consumer inflation has remained below the NBU’s forecast and target range in recent months. Specifically, after a long slowdown, inflation held steady in April and only slightly picked up in May, to 3.3% yoy. The weaker-than-projected price developments were primarily driven by temporary factors. However, the rather long period of low inflation contributed to a general improvement in inflation expectations, which appeared resilient even to a certain weakening of the hryvnia. The upbeat expectations for inflation offset the pressure from further growth in business costs. Core inflation was in line with the NBU’s forecast.

The FX market situation remained under control, though the hryvnia weakened, partly due to the effects of an increase in budget expenditures. To compensate for the structural deficit of foreign exchange and prevent excessive exchange rate fluctuations, the NBU maintained an active presence in the FX market. Accordingly, NBU interventions increased in May.

Although the balance of risks to inflation and exchange rate sustainability within the monetary policy horizon underwent certain changes, they were to a large extent mutually offsetting. On the one hand, there is a growing risk of additional budget expenditures arising to maintain defense capabilities amid protracted war, which will likely require implementing a number of tax increases and may affect inflation. On the other hand, Ukraine has been consolidating international support to repel russian aggression. This is reflected both in the growth of arms deliveries and in additional commitments by international partners to provide financing. In particular, when the MPC meeting was taking place, the G-7 countries were expected to approve the use of frozen russian assets on top of the decisions previously made in the United States and the European Union.

Favorable inflation developments, improved inflation expectations, and progress on securing international financing are creating opportunities to further ease monetary conditions to support the lending revival and economic recovery. 

Nine members of the MPC supported lowering the key policy rate to 13% in June

Such a measured step is currently an optimal solution, they said. It takes into account, on the one hand, current favorable macrofinancial developments and, on the other hand, a projected pick-up in inflation in H2 2024, and still significant risks due to the war’s consequences. What is more, this decision is consistent and most expected by financial market participants. First, it matches the key policy rate trajectory in the baseline scenario of the NBU’s April macro forecast and forward guidance. Second, it coincides with projections by the financial analysts polled in the latest surveys. Such a move by the NBU is already implied in expectations, so the financial markets’ response to it will be restrained and predictable.

These MPC members agreed that a cautious reduction in the key policy rate would also correspond to the NBU’s intention to protect households’ hryvnia savings from losing value to inflation. Despite the nominal decrease in market interest rates, the real yield on hryvnia deposits and domestic government debt securities amid improved expectations remains positive, and these instruments are still in demand. Among other things, this is evidenced by the continued uptrend in hryvnia term deposits that has been outpacing the growth in households’ FX savings in banks. The high demand for domestic government debt securities at the Ministry of Finance’s auctions, including long-term securities with two to three years’ maturity, is also informative in this regard.

It is important to support the appetite for hryvnia assets going forward to restrain pressure on the FX market and cover the budget deficit from market-based sources. To this end, it is necessary to maintain macrofinancial stability and sufficiently attractive real interest rates. One MPC member called for taking into account that the effects of previous decisions to loosen the interest rate policy are still materializing, and that it is worth continuing to proceed with caution and weigh the potential effects of every step.

Another MPC member said the positive shift in the matter of providing funds to Ukraine at the expense of immobilized russian assets also strengthens the case for lowering the key policy rate. However, a different MPC member said obstacles still exist that impede the use of this source of funding. First, there is no final understanding of procedure for allocating that money. Specifically, part of the promised funding may be tied to the implementation of certain reforms by Ukraine, a prerequisite that will affect the regularity of disbursements. Second, there is no clear-cut affirmation of the total amount that Ukraine needs for 2025 or would need if the budget deficit widened in 2024 to maintain defense capabilities. Third, the world is entering a turbulent season of elections, particularly in the U.S. and EU. Their outcomes may also affect the level of further support for Ukraine from international partners. A deterioration in the regularity of international aid and insufficient financing of the budget deficit remain the risks that, if materialized, may complicate efforts to maintain macrofinancial stability. Under such conditions, the NBU’s prudent steps are fully justified.

One discussion participant drew attention to the fact that core inflation matches the NBU’s forecast. This proves that headline inflation is not going to stay below its target for long, this participant said. Another participant agreed, adding that the weakening of the hryvnia that has occurred in recent months has yet to be fully reflected in inflation developments. It is rather likely that businesses have previously priced in a certain exchange rate markup and had the chance to partially absorb the uptick in import prices at the expense of profitability, an action that has been restraining inflation, among other things. Going forward, however, one should expect that the pass-through effect from a weaker hryvnia will still be reflected in a higher rate of inflation. This adds weight to the case for a reasonable easing of the interest rate policy that would be consistent with the NBU’s objective to keep inflation subdued this year.

Several MPC members agreed that although a significant number of pro-inflation risks persist, some of them are likely to materialize as disinflation factors. That includes an increase in power shortages due to russian attacks on the energy grid, which on the one hand leads to higher business costs but could on the other hand reduce consumer demand, restraining inflation. A similar situation already took place in late 2022 through early 2023 after russia’s first massive assault on the Ukrainian energy system. Developments unfolding in the labor market as a result of mobilization can also have a multidirectional impact on inflation.

One MPC member spoke in favor of cutting the key policy rate to 12.5% in June

The NBU can loosen its interest rate policy more quickly at the moment in order to support the economic recovery and stimulate the growth in long-term hryvnia investments, this MPC member said. Inflation expectations remain well-anchored. Actual inflation developments in May were better than forecast, and the rise in power tariffs was largely factored into the April macro forecast, this MPC member said. Even if taxes are raised as announced, inflation will probably just catch up with its forecast level and rise to 8%–9% this year. Meanwhile, the NBU should also consider the disinflationary factors that can significantly slow inflation within the monetary policy horizon. Those include a dampening effect on prices that is likely to come from a worsening of consumer and business expectations that is being observed amid persistent significant uncertainty over the duration of the war and the deterioration of the energy supply situation. Furthermore, intensified migration is possible, which will suppress consumption and curb inflation.

The task of ensuring the attractiveness of hryvnia savings is being carried out today. Should the key policy rate be reduced to 12.5%, it will continue to significantly surpass the current inflation rate, as well as the inflation rate anticipated by all groups of respondents. As a result, the real yield on domestic government debt securities and deposits will also stay in positive territory, meaning these instruments will be in demand. In addition, the banks’ active competition for depositors, especially large ones, will restrain the decrease in market rates. 

Moreover, a deeper cut to the key policy rate may encourage investors to more actively lock in a higher yield in long-term hryvnia instruments. By contrast, the projected decrease in the key policy rate – by only 0.5 pp – will not create such incentives. It will rather signal the NBU’s intention to continue to act in line with the forecast and, by taking such a step, to complete the easing cycle of interest rate policy in 2024.

One MPC member said the key policy rate should be left unchanged in June

The NBU’s interest rate policy should remain consistent and serve as an element of predictability, this MPC member said. This MPC member said that in a previous statement about the NBU’s intentions, this MPC member linked the next key policy rate decisions to changes in the balance of risks to exchange rate sustainability and inflation. This participant said that the balance of these risks has rather deteriorated in recent months. First, pressure on the FX market has risen, exchange rate expectations have worsened, and demand for FX cash has increased. Second, the implementation of initiatives to raise taxes seems highly probable and, along with the rise in utility tariffs, may have a rather significant contribution to inflation.

A reversal of the inflation trend already took place in May, and going forward, price pressure will intensify until Q2 2025, the current forecast shows. Given the additional potential impact on inflation from increases in indirect taxes and excise duties, this may have an adverse impact on inflation expectations, which are adaptive and usually respond to price increases after they occur. As a result, the attractiveness of hryvnia instruments may be at risk at some point.

In its turn, this may convince depositors to switch to FX savings, an action that will put more pressure on international reserves, the hryvnia exchange rate, and consumer prices. What is more, the decline in the attractiveness of the hryvnia will undermine progress on developing the culture of long-term savings and on ensuring that the banks can work with longer-term financial instruments. Therefore, the issue of maintaining the attractiveness of hryvnia-denominated instruments continues to be relevant. Accordingly, the NBU would be right to take a break from lowering its key policy rate now so as not to reverse monetary policy later. On top of that, transmission from the previous decisions to ease interest rate policy is still ongoing. 

MPC members also discussed possible changes to the parameters of the interest rate policy’s operational design

The discussion participants noted the important role that three-month certificates of deposit (CDs) play in ensuring the attractiveness of hryvnia savings in 2023 through H1 2024. This tool helped create strong incentives for revitalizing the banks’ competition for depositors and shape a sustainable uptrend in household demand for hryvnia term deposits and domestic government debt securities.

Three-month CDs will continue to be part of the mechanism the NBU operates to set monetary conditions and to influence market rate movements and thus the attractiveness of hryvnia instruments. As a result, the MPC members agreed that by changing the design of this instrument – including by further narrowing the spread between the key policy rate and the rate on three-month CDs – it is possible to ensure an additional easing of interest rate policy. At the same time, opinions differed over the viability and availability of the right macroeconomic prerequisites for continuing to move in this direction.

Citing favorable macroeconomic developments, some MPC members proposed to reduce the spread between the key policy rate and the three-month CDs rate at the current meeting already. Most MPC members supported narrowing the spread by 0.25 pp in addition to reducing the key policy rate. One discussion participant suggested trimming the spread by a more significant 1.5–2 pp in a single move, saying that such a step would pose no threats to the attractiveness of hryvnia savings.

Other MPC members, however, urged them not to rush this decision before updating the macroeconomic forecast and more thoroughly reassessing the balance of risks to inflation and the sustainability of the FX market. Doing such a double take will make it possible to determine if room is available for an additional easing of monetary conditions. The discussion participants also said the impact of previous decisions to optimize the operational design has not yet died down. The banks, market makers in particular, continue to revise their rates on hryvnia term deposits. More data is needed to comprehensively assess the effects of the previous steps and predict the possible consequences of a further narrowing of the interest rate spread.

The MPC members agreed to continue to discuss, at the July meeting, whether to further optimize the operational design of interest rate policy. Most discussion participants supported the need for this process to be gradual to avoid an excessive easing of monetary conditions and preserve the attractiveness of hryvnia instruments.

MPC members differed on the scope for further cuts to the key policy rate

Seven discussion participants said there is potential to bring the key policy rate down. Risks to the inflation forecast are fairly balanced, they said. Reasons also exist to expect the disbursement of sufficient amounts of external financing both this year and the next. With this in mind, the NBU will be able to cut the key policy rate to at least 12%–12.5% by the end of 2024, these MPC members said.

In contrast, four participants said the potential for lowering the key policy rate this year is all but used up. They said the balance of risks to inflation developments has edged higher, including due to significant budget needs, the expected pass-through effect from the hryvnia’s weakening, and the probable worsening of expectations as inflation accelerates. The key policy rate is highly likely to remain at 13% until at least the end of the year, the MPC members said.

At the same time, all participants agreed that given the high level of uncertainty, the NBU should be ready to flexibly adjust its monetary policy if shifts occur in the balance of risks to inflation and the FX market. In updating July’s macro forecast, the NBU will be able to better assess shifts in the balance of risks and prospects for further macroeconomic development, and will base its decision on a new, more complete picture of data and more detailed calculations.