Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 13 December 2023

Meeting date: 13 December 2023.

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
• Oleksii Lupin, Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department.

The MPC members discussed whether macrofinancial developments match the October forecast. Specifically, the MPC members noted the better-than-expected inflation dynamics, as well as the successful adjustment of the FX market to the new exchange rate regime. The discussion placed a special focus on the risk of irregularity and insufficiency of international aid disbursements.

The discussion participants mentioned that consumer prices displayed better dynamics than the NBU expected. Inflation slowed to 5.1% in November in annual terms. Price dynamics remained favorable primarily because of the cheapening of raw food products amid high harvests and difficulties with food exports. The increase in the supply of cheaper raw foods in the domestic market, among other things, eased some of the pressure on business costs, in particular those incurred by food companies and cafes and restaurants. However, the most significant factor in weakening the underlying inflationary pressure was the sustained stable situation in the FX market. This not only limited the growth in prices for a wide range of goods with an import component, but also helped improve exchange-rate and inflation expectations. As a result, core inflation also slowed, to 5.7% yoy. The NBU estimates that inflation readings will remain close to the current levels in December as well.

The FX market has successfully adjusted to managed flexibility of the exchange rate, a regime that was introduced in early October. The NBU covered the structural deficit of foreign currency in the interbank FX market on a daily basis and ensured that the exchange rate was free to moderately fluctuate in either direction, depending on the changes in the balance of FX demand and supply. As a result, concerns that surrounded the introduction of the new exchange rate regime died down quickly. As a matter of fact, the hryvnia strengthened in November, and the NBU gradually scaled back its interventions. Specifically, the balance of the NBU’s interventions amounted to USD 2.5 billion in November, down by 29% from October and by 10% from September. After the fixed exchange rate regime was abandoned, banks’ transactions without the NBU’s participation rose almost threefold in volume, signaling an increase in the depth of the interbank FX market and a strengthening of its resilience to ad-hoc factors. What is more, the lifting of restrictions on the sale of FX cash intensified competition in the cash market and helped narrow the exchange rate spread between the official and cash exchange rates to 2% at the beginning of December, down from 3%–4% in the autumn. This was also a significant factor in improving exchange rate expectations.

Given the decrease in inflation, the sustainable situation in the FX market, and more upbeat expectations, hryvnia-denominated savings instruments – deposits and domestic government debt securities – remained attractive even though interest rates declined in nominal terms in previous months. This was evidenced by the further growth in the volume of hryvnia retail deposits with maturities of three months or more. Incentives built into the operational design of the NBU’s monetary policy further supported this uptrend. In particular, transactions with three-month certificates of deposit, which offer increased interest rates and are conditional on how successfully banks can raise new retail term deposits, are encouraging banks to compete for depositors and ensuring a smooth reduction in rates on hryvnia term deposits. Market demand for domestic government debt securities also remains high although the Ministry of Finance has shifted down the primary market’s entire yield curve. Supporting the appetite for hryvnia instruments is restraining FX demand and pressure on the NBU’s international reserves to decline.

However, risks to inflation developments and exchange rate sustainability as the war drags on remain significant, and some have actually materialized in part. Among other things, the provision of external financial assistance to Ukraine has run into a delay, and uncertainty persists regarding the timing and volumes of future disbursements. Ukraine’s key partners – the European Union and the United States – have yet to approve their 2024 support packages for Ukraine. This issue will most likely be resolved in the coming months. The reasons for optimism include the successful completion of the second review of the Extended Fund Facility (EFF) for Ukraine and relevant assurances from international partners, which are an integral part of this program. Ukraine has almost USD 39 billion in international reserves. This is enough to retain control over exchange rate dynamics. However, the delay in resolving the matter of international financing may adversely affect expectations and thus fuel additional demand for foreign currency. Accordingly, the NBU should proceed with caution so as not to undo the gains made by ensuring exchange rate sustainability and moderate inflation.

At the same time, upside risks have materialized. In particular, the capacity of the new maritime corridor has surpassed the NBU’s expectations. About four million tonnes of cargo was transported via it in November, just shy of the maximum volume that went through the Black Sea Grain Initiative before russia ended it (4.2 million tonnes in November 2022). In the first 11 days of December, about 2.4 million tonnes of commodities passed through the new route, meaning the December figure may exceed the shipments made via the Black Sea Grain Initiative. In addition, the expansion of maritime logistics has mitigated the effects of the trade and transportation restrictions imposed by some EU countries. 

All MPC members endorsed a moderate reduction in the key policy rate by 1 pp, down to 15%

The discussion participants agreed that this is the most prudent decision under the circumstances. On the one hand, sustained favorable inflation dynamics, improved inflation expectations, and the FX market’s successful adjustment to the new exchange rate regime give the NBU leeway to continue to loosen its interest rate policy. On the other hand, the central bank is aware that risks associated with the regularity of external financial assistance disbursements have materialized. However, external financing is expected to resume in the near future.

One of the discussion participants emphasized that cutting the key policy rate in the current conditions is a difficult but justified decision. If the baseline forecast of economic development were to assume insufficient foreign aid in 2024, the NBU and the government would have to radically change the principles of their monetary and fiscal policy right now, this MPC member said. However, such an occurrence is unlikely, and the NBU should not deviate from its baseline scenario.

Another MPC member said that according to surveys, lowering the key policy rate to 15% also meets the expectations of market participants themselves. This is especially important now that uncertainty over external financing has increased.

The MPC members differed on the possibility of maintaining the cycle of easing the interest rate policy next year

Most discussion participants said there is room for making more cuts to the key policy rate in 2024. If the macroeconomic situation follows the baseline scenario closely and major adverse risks do not become reality, the NBU will be able to press forward with its cycle of key policy rate cuts, these MPC members said. An important prerequisite for this, among other things, is reviving the regularity of foreign aid inflows. This issue should resolve itself, as the main partners have declared an unwavering commitment to support Ukraine for as long as it takes.

At the same time, these MPC members agreed that in wartime conditions, the NBU should act carefully so as not to undermine macrofinancial stability. To maintain the sustainability of the exchange rate and the subdued pace of inflation, it is necessary to ensure that the attractiveness of hryvnia savings instruments remains relatively high. This leaves little space for a further reduction of the key policy rate next year: 1–2 pp at most, a few of the discussion participants said.

In contrast, several other MPC members said that it would be more appropriate to keep the key policy rate unchanged over the course of next year. Bank rates currently cover the anticipated rate of inflation, but do not exceed it by a wide margin. This can be seen from the slump in the growth of retail term deposits in October, as well as the increase in their dollarization amid concerns over the transition to managed flexibility of the exchange rate. In addition, the NBU should keep in mind that households’ inflation expectations are adaptive. The current improvement in their expectations is primarily driven by favorable exchange rate dynamics, this year’s plunge in inflation, and price decreases for some foods due to temporary factors. At the same time, the NBU’s forecast for 2024 envisages a moderate acceleration of inflation, meaning that a certain worsening of inflation expectations cannot be ruled out.

Uncertainty over international funding could stir up additional tension in the media and a deterioration of sentiment, these MPC members said. This would inflate the risk of a decrease in the real yield on hryvnia instruments, potentially prompting depositors to switch to foreign currency as a preferred way to make savings. This would in turn put more pressure on international reserves to shrink and on the hryvnia to depreciate. With this in mind, next year the NBU should suspend its cycle of key policy rate cuts in order to maintain the attractiveness of hryvnia savings instruments at the right level.