Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 15 March 2023

Date of the meeting: 15 March 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 changes in the balance of risks to inflationary and economic developments, as well as further measures to enhance the investment appeal of hryvnia assets. Such measures are necessary to preserve the stability of the FX market, the steady decline in inflation, and the formation of prerequisites for a gradual easing of FX restrictions.

During the discussion, it was noted that the economic situation in the earliest months of 2023 came out better than the NBU predicted in its January macroeconomic forecast.

First, inflation began to decline earlier and faster. In February, consumer price growth slowed to 24.9%. This was facilitated by a higher supply of food and fuel, a better situation in the energy sector, and the strengthening of the hryvnia in the cash FX market, including due to the NBU's previous measures. The fixing of the official exchange rate and utility tariffs also eased inflationary pressure.  The NBU’s complete cessation, since the beginning of the year, of the monetary financing of the budget deficit has also had a positive effect. Coupled with the slowdown in inflation and the stable situation in the FX market, the discontinuation of monetary financing helped improve inflationary and exchange rate expectations.

Second, the energy situation got better much more quickly than expected, thanks to unseasonably warm weather, air defense capabilities, and quick repairs after russian missile attacks. This improvement had a positive impact not only on inflation developments, but also on business activity indicators in various sectors. The stability of the energy system has given the economy additional room to continue to revitalize domestic production.

Third, the ability of the NBU and the government to maintain macrofinancial stability continued to strengthen. International reserves increased in January–February compared to the beginning of the year, driven by the economy’s high adaptability to wartime challenges, regular inflows of official financing, and the measures previously taken by the NBU to take pressure off the FX market.  International reserves currently stand at a rather comfortable level (USD 28.9 billion as of 1 March 2023). It allows the NBU to confidently balance out supply and demand in the FX market.

The NBU’s and the government’s joint measures, specifically the mechanism to cover part of the banks’ reserve requirements with benchmark domestic government debt securities, have revived the market for domestic sovereign borrowing. Regular international aid disbursements and the government’s proactive efforts in the domestic debt market have made it possible to fully cover the budget deficit, even if it widens, without resorting to monetary financing. Progress made in discussions with the IMF comes as an additional affirmation in this regard.

However, risks to inflationary and economic developments remain significant, primarily due to the war. The high uncertainty surrounding the further course of hostilities is impeding the economic recovery and leading to the emergence of still-high inflationary and depreciation expectations. As a result, the demand for foreign currency remains significant, and the FX market continues to rely on the NBU’s interventions.

In addition, risks persist that the grain corridor may cease to operate, as russia is constantly threatening to disrupt it. And there is pressure from extremely high balances on current accounts in the banking system as hryvnia-denominated assets continue to lack in attractiveness. What is more, inflationary pressure from Ukraine’s major trading partners is significant, and bank failures in the United States and Europe have only made it more difficult for leading central banks to tackle inflation.

Having considered the balance of risks, the MPC members unanimously spoke in favor of keeping the key policy rate at 25%, for the sixth time running.

The discussion participants agreed that maintaining tight monetary conditions is necessary to keep the exchange rate stable, reduce inflation, and improve expectations. On the one hand, inflation risks on the policy horizon are relatively balanced, and progress in maintaining macroeconomic stability is also evident. On the other hand, security risks and exceptionally high current account balances require the central bank to weigh each action very carefully before taking it. The need to proceed with caution is increasingly important, considering that inflation has long remained at high levels, and that the threat of a further unanchoring of inflation expectations is still there.

For instance, a premature lowering of the key policy rate – before a sustained reduction in inflation – could weaken the impact of the NBU’s previous measures, erode confidence in its monetary policy, and intensify pressure on the FX market. In contrast, keeping the key policy rate at 25% will support positive trends in the FX market and contribute to making hryvnia assets more attractive. In the long run, this will enable the central bank to gradually roll back its FX restrictions without causing shocks to the economy and the financial market.

Going forward, the MPC members expect the NBU to continue to pursue a fairly tight monetary policy, but most of them believe that, if there is a sustained slowdown in inflation, a cycle of key policy rate cuts may begin earlier than the January macroeconomic forecast predicted.

Eight members of the MPC expressed a view that the regulator may switch to key policy rate reductions earlier than envisaged in its January macroeconomic forecast. A further stable and faster-than-expected slowdown in inflation can be a strong argument for cutting the rate. During the discussion, most MPC members did not specify either when or how much the key policy rate may decrease. They emphasized that it is necessary to wait for the updated macroeconomic forecast.

At the same time, the NBU may launch a cycle of key policy rate cuts as soon as the autumn, two MPC members pointed out. Another participant did not rule out that the prerequisites for such a decision may emerge even earlier. In addition to a quicker reduction in inflation, other prerequisites are being formed, this MPC member said. Specifically, pressure on the FX market is moderating, and the prospects for keeping international reserves at a sufficiently high level are improving, as progress in the talks with the IMF has shown.

By contrast, several MPC members urged their colleagues not to jump to conclusions about the change in the key policy rate forecast. Future decisions on the rate should take into account the high uncertainty around how the battle zone situation may unfold, one of these MPC members said. In addition, this MPC member expressed concern over the potential fallout from a new global financial crisis following the failure of a number of large Western banks. The maintenance of the high key policy rate since July 2022 has been one of the measures that have contained the deterioration of expectations and stabilized the FX market even as the large-scale war grinds on, this discussion participant said. Going forward, the market anticipates that the NBU will pursue a balanced policy.

The NBU is currently working on a plan to ease the FX market restrictions, and so the trajectory of the key policy rate should be consistent with this plan, another participant in the discussion said. This opinion was endorsed by the majority of the MPC members. With the balance of risks being what it is now, the need for an additional tightening of monetary policy should not be neglected, a different MPC member said.

The discussion participants unanimously spoke in favor of changing the mechanism for calculating the reserve requirements (RR), while the majority advocated optimizing the operational design of monetary policy.

The MPC members highlighted the effectiveness of the NBU’s previous measures, including efforts to keep the key policy rate elevated, tighten the RR, calibrate the FX restrictions, create additional tools to protect savings, and make verbal interventions. First, the NBU’s efforts contributed to a significant improvement in the FX market situation. Second, they encouraged the banks to more actively raise hryvnia term deposits and stimulated a further increase in the interest rates on these deposits. The banks that increased the rates more actively were able to improve the term structure of the deposit base the most. This goes to show that the profitability of hryvnia assets has a significant impact on savings decisions.

However, the rates on term deposits of the largest banks will continue to stop short of being attractive to depositors, given the high level of current and expected inflation. Therefore, because of the limited number of lucrative savings options and out of an abundance of caution, households have been choosing to keep their money in current accounts. This problem could grow in intensity, as the budget deficit stands to remain significant during 2023. On the one hand, this issue could resolve itself as the security situation improves. On the other hand, the war is generating significant risks to macrofinancial stability. This means that the NBU should take additional steps that will encourage the banks to more actively compete for term deposits and that will increase the investment appeal of hryvnia assets. Such steps will preserve FX market stability and ensure a sustained decline in inflation.

The discussion participants unanimously supported the proposal to equalize the RR for retail deposits that have up to three months’ maturity with the RR for households’ funds in current accounts. The MPC members agreed that given the need to incentivize retail term deposits, the maneuvering with quasi-term deposits that some banks have engaged in to evade the tightened RR is counterproductive.

Several MPC members offered to extend this approach to the RR for corporate deposits in order to further tie up the banking system’s liquidity and prevent foreign currency from leaving Ukraine. But other participants did not endorse this proposal. Corporate deposits are meant to be used for running a business, not for earning interest from a bank, one of these MPC members said. The banks are already competing more actively for corporate deposits and offering them even better terms than to households.

One of the MPC members proposed to apply a preferential RR rate to deposits with at least one month’s maturity, as short-term profitable deposits are what interest depositors the most. Tying up free funds even for a month will be sufficient to reduce risks, this MPC member said. But this idea garnered no support from other participants in the discussion either.

Most MPC members also supported the adjustment of the operational design of monetary policy. This is about cutting the rate on overnight certificates of deposit (CDs) to 20% and introducing three-month CDs with a rate fixed at the level of the key policy rate. The volume of the placement of three-month CDs will be determined by the part of the volume of the existing portfolio of hryvnia retail deposits with an initial term of at least three months and by the subsequent growth, times a multiplier, in such deposits.

According to the discussion participants who supported this decision, the new operational design will give the banks more incentives than its predecessor to step up competition for term deposits. First, it will expand the space for further increases in deposit rates, as three-month CDs will be placed at the key policy rate, which stands at 25%. Second, additional incentives will arise from the greater differentiation of rates on CDs with various maturities. Third, because of the multiplier effect, the banks that actively participate in the competition for term deposits will have the chance to build up their volumes of CDs at a rate of 25% in the short run.

As a result, at least part of the banks will find it beneficial to take their work with depositors to a new level, to ramp up their marketing efforts, and to further increase interest rates on hryvnia term deposits. Another group of the banks will be forced to at least follow the market to maintain liquidity and not lose customers, whose trust is always difficult and expensive to win back. Individual banks may continue to place their free funds, accumulated primarily on current accounts, into overnight CDs. From now on, however, such transactions will yield lower revenues, both due to changes in the operational design and because of the update to the RR calculation protocol.

At the same time, three MPC members pointed out that incentives from such changes may prove insufficient to significantly intensify the banks’ competition for depositors. Amid a high flight to liquidity, the banks will be hard-pressed to quickly build up their term deposit portfolios to take advantage of investments in long-term CDs. Instead, the increase in the rates on new deposits will generate significant additional interest expenses for the banks from the rollover of existing term deposit balances.

Increased interest expenses will indeed be partially offset by the permission to place part of the already formed deposit portfolios into three-month CDs. However, these MPC members said, such permission will dampen competition incentives for the banks that have already built up portfolios of retail term deposits. If retail term deposits do not increase, the effective key policy rate will actually decline. As a result, monetary conditions may weaken, despite efforts to keep the key policy rate unchanged.

Meanwhile, most participants in the discussion agreed that the weighted average interest rate of NBU transactions will not undergo significant changes. One MPC member said that the banks will, from the outset, have the opportunity to put a significant part of their portfolio of hryvnia retail deposits with at least three months’ maturity into three-month CDs, meaning that the expansion of the lower bound of the interest rate corridor will be offset by transactions with long CDs at 25%. Therefore, even with the adjustment of the operational design, monetary conditions will remain sufficiently tight for the NBU to achieve its goals.

Another participant in the discussion said that the rigidity of monetary conditions is determined less by the nominal weighted average interest rate of NBU transactions than by the strength of the impact of interest rate policy on the behavior of economic agents. With this in mind, there will be no significant loosening of monetary conditions, as the new operational design will, on the contrary, make hryvnia assets more attractive and further incentivize economic agents to make hryvnia term deposits. It will also entrench the status of the key policy rate as an effective tool with a powerful impact on money market conditions and economic agents’ business behavior.

Some discussion participants also noted that the proposed changes would make the operational design too complex and thus potentially pose communication challenges and intensify “trailblazer risks.” Moreover, it is difficult to quantify the effects of the implementation of the new operational design in advance. The period for which monetary instruments are introduced should not exceed the time interval between MPC meetings, one of these MPC members said. In contrast, the new operational design envisages the use of three-month CDs for at least a year. This will make it easier for the banks to plan their deposit strategies, but will simultaneously reduce the flexibility of monetary policy, especially amid exceptionally high uncertainty.

According to another MPC member, the complexity of the operational design may be excessive, given the stimulating effects of the measures already in place. The central bank should instead wait until the RR tightening and verbal interventions play out in full, and then see if any changes to the operational design are necessary. In addition, this MPC member said, it would be desirable to adjust the operational design concurrently with the macroeconomic forecast update that is scheduled for April. However, most MPC members did not support postponing the operational design changes.

Several discussion participants immediately countered that it is pointless to try to solve what is clearly a nonmarket problem by using purely market-based methods. The top banks, which are the least active in terms of raising rates, are enjoying noncompetitive advantages in terms or drawing funds into current accounts. Such a privileged position has been reducing their sensitivity to the NBU’s market-driven instruments. A proper response of these banks to the NBU’s policy is important for immobilizing funds by channeling them away from current accounts and into term deposits. To meet the identified objective more quickly and more efficiently, market-based incentives should be amplified by administrative controls available to the NBU for the duration of martial law, if need be, these MPC members said. This opinion was supported by the rest of the committee.

While discussing the impact of the operational design on the domestic debt market, the MPC members concurred that the proposed changes would not have a significant impact on the primary-market placements of domestic government debt securities. The banks’ capability to acquire three-month CDs will be limited. Thanks to the increase in government spending, the banks will have sufficient liquidity to invest in domestic government debt securities. Furthermore, the domestic government debt securities designated for primary-market placement do not currently include bonds with up-to-one-year maturity, meaning that three-month CDs will not come into outright competition with domestic government debt securities. Rather, operational design adjustments will contribute to the gradual emergence of a culture of long-term hryvnia savings among households, and to the extension of the term structure of bank funding. In the long run, this will enhance the banks' capability to invest in long-term domestic government debt securities.

It was also noted during the discussion that the new operational design will meet the prerequisites for revitalizing the banks’ activity in the interbank market. The banks that will have competitive advantages in raising term deposits but that will lack liquidity to invest in three-month CDs will be interested in receiving liquidity from other banks in the interbank credit market, an incentive that will jump-start this market’s development.