Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 19 October 2022

Date of the meeting: 19 October 2022.
Attendees: all ten 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
• 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, MPC members discussed possible scenarios of economic development under conditions where high security risks may persist longer than was expected in July, and changes in the balance of key risks to inflationary dynamics. Special attention went to the assessment of previous measures to ensure exchange rate stability, as well as potential steps to strengthen monetary transmission.

The dynamics of the main macroeconomic indicators are quite close to the NBU’s July forecast (July 2022 Inflation Report), the MPC members noted. In recent months, inflation has been marginally lower than expected, and business activity has revived somewhat. Specifically, this has been due to the faster stabilization of fuel prices as logistics improved, the preservation of preferential taxation, and the successful operation of the grain corridor. However, this has not had a significant impact on the NBU’s macroeconomic forecast, as russia has ramped up its terrorist attacks, and the forecast’s core assumption about the duration of security risks has shifted towards their longer duration.

It is expected that this year inflation will be about 30% (down from the 31% projected in July), and that Ukraine’s GDP will fall by 31.5% (compared to 33.4% in the July forecast). As the war grinds on, it continues to generate additional negative shocks that limit the speed of Ukraine’s economic recovery.

Short-term risks to the economy have eased. This has been facilitated by the Ukrainian Armed Forces’ successful operations on the frontlines, the further adaptation of businesses and households to life under martial law, the intensification of international aid, and the positive impact of the NBU’s and the government’s crisis measures. Business activity has stabilized, albeit at a much lower level than before the war. At the same time, the grain corridor has contributed to the recovery of exports, which has reached their highest level since the war broke out.

International support for Ukraine has expanded as russia perpetrated new war crimes and scaled up its attempts at energy and nuclear blackmail. This has helped the NBU maintain an appropriate level of international reserves and ensure exchange rate stability. In addition, thanks to regular inflows of official funding, the government has been able to finance critical expenditures on time, and the NBU has rolled back its monetary financing effort. In recent weeks, FX market conditions have improved as ad-hoc factors faded, monetary financing volumes declined, and the NBU took all necessary measures. This has had a positive effect on inflation expectations, which are showing early signs of stabilizing.

On the other hand, midterm and long-term risks to economic development are increasing. The war has shifted into war-of-attrition mode, and russia has taken its terrorist acts to a new level by launching what appears a full-blown premeditated terrorism campaign. As a result, the Ukrainian economy will continue to suffer significant losses from the war’s death toll, the migration of citizens, the wrecking of critical infrastructure, supply chain disruptions, and the destruction of businesses and production facilities. What is more, there is a risk that the grain corridor may stop working and Ukraine’s Black Sea ports may shut down due to russia’s military aggression. This risks further depressing business activity, aggravating supply chain disruptions, and causing significant imbalances of expectations for inflation and exchange rates.

In such conditions, it remains vital that international partners continue to support Ukraine. As 2022 has shown, the irregularity of announced aid inflows can significantly worsen the macrofinancial situation, as this irregularity forces the government to ask the NBU for more monetary financing of public debt so that Ukraine can meet its critical expenses.

In addition to the domestic inflationary shocks triggered by the war, strong external inflationary pressures persist. The global economic slowdown will be a significant factor in the gradual decline of energy prices, but they will remain rather high. At the same time, prices for Ukraine’s main export goods (foods and metals-and-mining products) are expected to drop, which along with the war-related factors will limit FX inflows to the country.

Based on this balance of risks, the MPC members, for the third time running, unanimously spoke in favor of maintaining the key policy rate at 25%

Such a decision takes into account the proximity of the actual inflation rate to its forecast levels and market expectations about the key policy rate, as well as the balance of inflation risks, which remains shifted upwards, the discussants pointed out. Keeping the key policy rate high is necessary to continue to make hryvnia assets more appealing and to ease FX market pressures. This will make it possible to keep inflationary expectations and processes under control and ensure that inflation decelerates as soon as next year, the MPC members agreed.

Several discussants highlighted the fact that inflationary pressure is already showing the first signs of stabilization. Evidence of this includes the improved dynamics of annualized seasonally adjusted increases in headline and core inflation in recent months, as well as the slowdown in the growth of inflation expectations of most groups of respondents. However, the NBU should proceed with caution as it interprets these signals, because the war’s shift into a protracted stage, the volatility of exchange rate and inflation expectations, and the inflationary pressure affecting about 90% of the consumer basket are increasing the risk that the inflationary spiral may continue to unfold.

The MPC members agreed on the need to continue to take additional measures to safeguard international reserves and shore up the monetary transmission mechanism

On the one hand, the transmission of the June hike, which brought the key policy rate to 25%, to market rates is close to the NBU’s “pre-war” model response and expectations. Specifically, many banks with private capital have since June raised their deposit rates to 15%–20%. The secondary market yields on domestic government debt securities with maturities of at least one year are gravitating to levels above 20%. The peak primary market yields on domestic government debt securities also increased to 18.5% in October. The Ministry of Finance’s raising of the rates on hryvnia domestic bonds has resulted in stronger demand for these instruments. This confirms that the market is putting primary importance on the level of interest rates, one MPC member said.

On the other hand, despite nominal growth, real interest rates on hryvnia assets are still negative if one takes into account the expected rate of inflation in 2022–2023. This significantly restrains the demand for these instruments and, seeing as exchange rate expectations have deteriorated, stimulates economic agents to look for other ways of protecting their savings (including by purchasing foreign currency and imported goods). The record surplus of hryvnia liquidity in the banking system is impeding monetary transmission and making the FX market more sensitive to spontaneous factors. Specifically, the adverse news fueled by russia’s mobilization and threats to escalate the war, hearsay about future exchange rate dynamics, and temporary disruptions in the FX cash resupply of bank vaults resulted in the FX market’s cash segment coming under elevated pressure in September.

At the same time, the term structure of hryvnia deposits continues to deteriorate. All of this is making it increasingly vital to take additional measures to safeguard international reserves and fortify monetary transmission.

The discussants noted the positive impact of the previous measures to calibrate currency restrictions. In addition, one of the factors in stabilizing the FX cash market situation was the introduction of the option to purchase foreign currency online to make FX term deposits. This product contributed both to increasing the supply of FX cash from households and to reducing the demand for it. The new instrument also had a positive effect on exchange rate expectations.

To amplify the effects noted above and immobilize the hryvnia supply, the MPC members considered introducing hryvnia deposits protected from exchange rate fluctuations, another novel instrument. The distinguishing feature of the proposed product is the absence of limits on the size of deposit, meaning that bank clients will be able to insure the desired amount of their savings against changes in the official hryvnia exchange rate at any time, several MPC members emphasized. As a result, the very presence of this instrument in the range of tools protecting hryvnia savings, even when demand for such deposits is low, will have a positive effect on the expectations of households by helping ease pressure on the cash hryvnia exchange rate.

The MPC members also discussed in more detail the design and practical aspects of applying a set of other potential measures to immobilize the banks’ excess hryvnia liquidity. In particular, options for increasing the required reserve ratio received a lot of attention from the MPC members.

They agreed that raising the required reserve ratio allows for a fairly accurate and early assessment of the volume of additional tied up liquidity, and that it will have a relatively quick effect. This measure will encourage the banks to more actively compete for depositors, thus accelerating monetary transmission, easing FX market pressures, and improving the term structure of bank funding. It is not for nothing that increasingly more central banks in emerging markets have been scaling up the use of this traditional monetary tool to optimize the liquidity surplus accumulated in part through quantitative easing efforts in previous years. For instance, since the beginning of 2022, required reserve ratios have been raised by the central banks of Poland, Hungary, Moldova, Egypt, Ghana, and Indonesia.

However, several MPC members emphasized that such a tool is not market-driven, and that it is important to identify the specific parameters of its design. In particular, on the one hand, by raising the required reserve ratio, the central bank can sterilize a significant amount of excess liquidity and create incentives for the banks to compete primarily for long-term deposits (for which monetary transmission is weaker). Based on this rationale, the MPC members agreed that the increase in the required reserve ratio should in any case apply primarily to demand deposits (both hryvnia and FX ones), while the current reserve ratio for existing term deposits should be left unchanged.

On the other hand, it is important not to harm the monetary transmission mechanism and the stability of the financial system. This analysis allows for determining the optimal size of a required reserve ratio increase that will have a limited impact on liquidity without putting financial system stability at risk. At the same time, the volumes and sources of financing the budget deficit next year, which are being negotiated with international partners, will have a significant effect on the banking system’s liquidity and monetary transmission. The MPC members therefore agreed that to identify the optimal design of the required reserve ratio’s application, it is worth waiting for the results of consultations between the NBU, the Ministry of Finance, and the IMF.

The MPC members also considered various options for the implementation of transactions to sell the domestic government debt securities held by the NBU. The design of such transactions may depend on the type of securities put up for sale (inflation-indexed ones, floating-rate ones), the NBU’s commitment to buy these securities back, the proposed yield, restrictions on the amount of sale and redemption of domestic government debt securities, and more. As with the required reserve ratio, the anticipated effect of such transactions will be quite sensitive to their specific parameters. The MPC members concurred that, overall, enabling market players to buy government bonds with a yield close to the key policy rate will positively affect monetary transmission and take pressure off the exchange rate and international reserves.

At the same time, the discussants agreed that the same effect can be more easily achieved by the Ministry of Finance if it continues to raise the interest rates on the domestic government debt securities issued through primary auctions. The MPC members therefore commended the results of the 18 October auction, where the maximum rate on domestic government debt securities rose to 18.5%. Several discussants pointed out that the further convergence of yields in the primary and secondary markets for government bonds can significantly improve monetary transmission even without the NBU making its own transactions with domestic government debt securities.

The lack of effectiveness of this monetary transmission channel is largely due to noneconomic factors, among other things, several MPC members said. It is therefore necessary for the NBU to try once again to build a constructive relationship with the Ministry of Finance on the basis of understanding by the two institutions of their shared general mandate, which is to defeat the aggressor state. It is also important for the market to feel that the financial authorities work to achieve the same goal and understand their common tasks and objectives while respecting the difference between the mandates of separate institutions. Under such conditions, market players will take greater interest in investing in hryvnia assets. In addition, this MPC member emphasized the need for a thorough and objective analysis of the reasons for the insufficient monetary transmission of the June decision to raise the key policy rate. This discussant also drew attention to the expediency of assessing the necessary changes in the parameters of monetary instruments to achieve the desired transmission effects both in terms of speed and scale. This will allow monetary measures to be calibrated accordingly. 

As the meeting drew to a close, the discussants concurred that finalizing the optimal parameters of the proposed instruments, as well as making decisions about the expediency of their use, should be done after the discussion of the general operating framework of macrofinancial policy with the IMF mission. The parameters of the NBU’s measures outlined above should be designed on the basis of the specific features of the budget policy and the pricing policy for government bonds. The effectiveness of monetary transmission channels largely depends on those specific features.

All members of the MPC believe that in order to maintain macrofinancial stability, the NBU will continue to pursue a relatively tight monetary policy for a long time

The MPC members believe that the previous forecast of the key policy rate, specifically that it will stay at 25% until mid-2024, generally looks reasonable as the war of attrition wears on. Moderately tight monetary conditions will likely play an important role both during active hostilities and in the early stages of post-war recovery. This monetary policy approach will ensure a sustained slowdown in inflation, laying the groundwork for cutting the cost of credit and speeding up the economic recovery.

However, alternative points of view regarding the timing and nature of the future cycle of monetary policy easing were also voiced. In particular, two MPC members suggested that this cycle can be quite slow if the war drags out even longer, which will adversely affect the expectations of businesses and households. In contrast, another MPC member noted that the announced volumes of international aid, amid Ukraine’s successful military operations, give reason to talk about a faster reduction of the key policy rate than predicted by the forecast. Significant FX inflows can greatly simplify the NBU’s task of ensuring exchange rate stability and keeping inflationary processes in check.

All MPC members agreed that given the extremely elevated uncertainty, there is a wide and upshifted range of potential key policy rate trajectories. The end of the war and the implementation of a large-scale recovery plan for Ukraine will indeed contribute to the rapid easing of monetary policy. In recent months, however, the uncertainty surrounding the timing and nature of the war has heightened, and the balance of risks on the monetary policy horizon has shifted upwards. If these risks materialize, the NBU should therefore be prepared to take an even tighter monetary policy approach than the current baselines scenario anticipates.