Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 20 July 2022

Date of the meeting: 20 July 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. 

At the meeting, the MPC members analyzed the impact of previous monetary policy decisions on the economy and outlined various scenarios of economic development, depending on security risks and macroeconomic policy measures. Special attention was paid to discussing next measures of monetary and foreign exchange policies that would maintain macrofinancial stability even under conditions of a protracted full-scale war.

The discussion participants noted that the inflationary pressure increased faster than expected. Inflation reached 21.5% in June due to effects of the war, in particular the disruption of supply chains, destruction of production facilities, and high global energy prices. Fixing natural gas and heating prices and an improvement in supply of goods restrained price growth only partially. As a result, the inflationary pressure affected more than 80% of the consumption basket, and economic agents’ expectations continued to deteriorate (the expectations ranged from 13% for households to 23.6% for bank credit managers).

According to the baseline scenario of the NBU’s updated macroeconomic forecast, the inflationary pressure will persist. Despite the reversal of the inflation trend in H1 2023, inflation will be declining gradually, remaining much above the NBU’s target of 5% for a long time. Specifically, inflation at the end of 2023 will decrease to about 20%, and in 2024 to single digits. The discussion participants agreed that the balance of inflation risks remains considerably tilted upward over the entire policy horizon.

The MPC members were also unanimous in believing that fixing the exchange rate at USD/UAH 29.25 at the onset of the war allowed containing the panic and inflationary pressures, thus maintaining the resilience of the economy.  Such exchange rate regime not only had a direct restraining effect on growth in the cost of goods and services (in particular, thanks to selling foreign currency at the official exchange rate to procure critical imports), but also put the brakes on underlying pressures by influencing inflation and exchange rate expectations of households and businesses. According to the NBU’s estimates, if the exchange rate had not been fixed, inflation would have been around 8 pp higher in June, meaning it would have jumped to 30% yoy.

At the same time, the underlying characteristics of the Ukrainian economy have changed a lot over the five months of the war. The war caused major disruptions of supply chains, physical destruction of production facilities and infrastructure, temporary occupation of some territories, and an increase in migration. Naturally, this affected the exchange rate fundamentals.

The initial psychological shock is subsiding, and economic agents are adapting to the war. Businesses started to look for ways to maximize their profits, in particular by using various optimization schemes and finding loopholes in restrictions. While households spent money mainly on staple goods at the start of the war, consumer demand has been reviving in the last months. Ukrainians have also started looking for ways to protect their savings. As a result, consumer imports, in particular imports of nonstaple goods, recovered much faster than exports, which were more affected by the sea port blockade. 

Conditions on global financial markets changed as well. In particular, since the start of the war, the U.S. dollar has strengthened markedly against the majority of currencies, including by 10%–15% even against the world’s reserve currencies. Therefore, the fixed exchange rate of the hryvnia against the U.S. dollar led to the strengthening of the hryvnia against other currencies. 

As a result, the pre-war exchange rate of the hryvnia lost its stabilizing effect, started causing more imbalance in the economy, and created high pressure on international reserves. In particular, in June, the NBU’s interventions to sell foreign currency soared to record-high USD 4 billion. 

The MPC members voted unanimously for adjusting the hryvnia exchange rate

The MPC members agreed that the exchange rate policy needed to be adapted to new economic conditions. Keeping the exchange rate at the pre-war level was considered unjustified in view of the major structural changes in the Ukrainian economy, its gradual adaptation to the war, and the drastic change in the global financial markets environment. Furthermore, preconditions for changes in the exchange rate policy were partially formed in the past months. This included an improvement in export logistics and a revival of  imports, which are susceptible to exchange rate fluctuations and thus to price changes. The government’s decision to re-impose import duties was also important for balancing the FX market. In turn, the NBU also took a number of measures, particularly to reduce nonproductive capital outflows to foreign countries and improve the attractiveness of hryvnia assets.

A the same time, the FX market is still building its ability to self-balance. Despite the progress made in the negotiations on unblocking the sea ports and alternative export logistics being arranged gradually, the potential for increasing FX proceeds from exports remains limited. Funding from international partners is not rhythmical. On the other hand, a deterioration in exchange rate expectations, in part driven by the increased monetary financing of the budget, is encouraging speculative demand for foreign currency and imported goods. This leads to the persistence of significant fundamental and situational mismatches between supply and demand on the FX market.

Under such conditions, returning to floating exchange rate would have been premature, including with regard to sparing international reserves. The loss of the nominal anchor to stabilize expectations – and thus a longer time needed to find the equilibrium exchange rate, which would probably be much higher – would have led to greater imbalance on the FX market and, hence, to large expenditures from the international reserves to balance the fluctuations. 

Therefore, with the war becoming protracted, the discussion participants saw an optimal solution to adjust the hryvnia exchange rate by 25% and fix it at a new level of USD/UAH 36.5686 per USD. 

The exchange rate will continue to serve as a nominal anchor to stabilize the expectations of businesses and households, and will therefore simplify the NBU’s task of maintaining macrofinancial stability. A one-time exchange rate adjustment will make it possible to reduce the demand for noncritical imports (which is more price elastic), improve the competitive edge of domestic production, and stimulate exporters to sell their FX earnings. At the same time, surveys of market participants have shown that such an exchange rate adjustment will not take them by surprise, but that it will bring the official exchange rate closer to its expected level and thus weaken speculation-driven demand for foreign currency.

Thanks to external financing and the adjustment of the exchange rate policy, it will be possible to maintain international reserves at a sufficient level, which will in  turn strengthen the NBU’s capability to control expectations and the trajectory of exchange rate and inflation trends.

The exchange rate adjustment itself will have a limited effect on inflationary processes, as a higher exchange rate has already been priced into many goods, while importers will have to partially absorb the exchange rate effect by reducing their markups amid a narrowing of domestic demand, despite its recovery. 

Several participants in the discussion emphasized that the exchange rate policy adjustment was a necessary measure, but that it should not be perceived as a sign that the NBU will review the exchange rate level on a regular basis. Going forward, the NBU’s decisions regarding the exchange rate will also be based on fundamental changes in the Ukrainian economy and global financial market conditions.

At the same time, to achieve a comprehensive effect, the NBU should take additional measures, simultaneously with the exchange rate adjustment, to balance FX demand and supply and ease pressure on the exchange rate, the MPC members agreed. Specifically, to ease demand in the FX market’s cash segment, the banks should be allowed to sell cashless foreign currency to individuals for the purpose of depositing it for three calendar months or more, without the right for early termination, within the monthly limit of the equivalent of UAH 50,000. 

In addition, restrictions should be tightened to minimize unproductive capital outflows from the country and preserve international reserves. To this end, it is necessary to impose a UAH 100,000 monthly limit on card-based payments abroad, to lower to the equivalent of UAH 30,000, from the equivalent of UAH 100,000, the monthly cap on P2P transfers abroad by individuals from Ukrainian-issued hryvnia cards, and to make the monthly limit on cash withdrawals abroad from hryvnia cards a weekly limit.

In addition, in order to limit the potential speculative demand for foreign currency, changes should be made to the banks’ algorithm for calculating the limits of open currency positions as regards not taking into account the increase in provisions for FX assets.

The MPC members unanimously offered to leave the key policy rate unchanged at 25%

The decision to keep the key policy rate at 25% is currently the only option available, the MPC members agreed.

On the one hand, this key policy rate level corresponds to high risks of a deterioration in expectations, an inflationary spiral, and a loss of financial stability and confidence in the NBU. The interest rate on the NBU’s certificates of deposit now also stands at a level that allows the system to absorb the structural liquidity surplus, ensure the pass-through of the effects of the key policy rate hike to the banks’ interest rates, and thus restrain inflationary and depreciation pressures. 

On the other hand, there is still high potential for an additional disinflationary effect from the previous key policy rate increase to 25% from 10%. This potential is driven by the strengthening of monetary transmission and the increase in market rates due to both effective cooperation with the Ministry of Finance and the implementation of additional measures by the NBU.

The further pass-through of the impact from the June key policy rate hike will be reflected in the growth in market rates and will continue to make hryvnia assets more attractive. This will protect Ukrainians’ hryvnia income and savings from inflation. Coupled with the adjustment of the official exchange rate and additional FX policy measures, this will also curtail demand in the FX market, and thus reduce market fluctuations going forward.

The NBU continues to take a flexible policy approach, one of the discussants pointed out. If under existing conditions the effectiveness of the key policy rate as the main policy tool is limited, then the regulator should adapt to such conditions by deploying all available policy instruments, including the exchange rate policy, to achieve its priority goal of ensuring price stability.

All MPC members believe that the NBU will continue to pursue a tight monetary policy for a long time to keep inflationary expectations in check and thus restrain inflationary and depreciation pressures

Numerous studies have shown that regardless of what triggers an inflationary surge, a protracted significant rise in prices has a negative impact on inflationary expectations, which can result in the unfolding of an inflationary spiral. The discussants therefore agreed that the NBU needed to be proactive and maintain tight monetary conditions to keep expectations for price developments under control.

The announcement of the key policy rate forecast and plans to keep this rate high for a long time will further improve the monetary transmission mechanism. According to polls, a significant number of financial market participants believed that the NBU would rapidly return to its monetary policy easing cycle and were therefore in no rush to revise their own interest rate policies. And although the key policy rate forecast is not a commitment, its publication will reaffirm the NBU’s readiness for a protracted period of tight monetary conditions, and will encourage the banks to respond more quickly to the June increase in the key policy rate.

Several MPC members noted immediately that the NBU had never published a forecast with such a high level of uncertainty, and that it was therefore necessary to be ready to adapt to dynamic changes in economic conditions. The most serious risks are now a longer duration of the war and a delay in taking steps to reduce the monetary financing of the budget deficit. These risks could have adverse consequences for inflation and economic growth. Maintaining macrofinancial stability during the war will require the NBU to continue to take a flexible policy approach and respond to new threats quickly. Participants to the discussion agreed that if required, the NBU should be ready to raise the key policy rate and the rates on its monetary operations above the current levels, as well as take additional measures to protect international reserves, improve monetary transmission, and rein in inflationary pressures.

At the same time, all MPC members noted that coordination of the NBU’s monetary policy with the government’s policy was gaining increasingly more importance. Narrowing the budget deficit, replacing monetary financing with borrowing from the market, and reducing imports through additional taxation are critical for ensuring long-term macrofinancial stability. Balancing state finance will reduce the need in monetary financing and help improve expectations and monetary transmission.