Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 24 July 2024

Meeting date: 24 July 2024.

Attendees: 10 out of 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

MPC Members discussed the new macroeconomic forecast, changes in the balance of risks, and the parameters of the monetary policy tools that will maintain the sustainability of the FX market, keep inflation moderate in 2024–2025, and bring it to its 5% target within the forecast horizon

Although inflation is still low, it has been trending higher since May, when its downtrend reversed. In June, inflation picked up to 4.8% yoy, the discussion participants said. Underlying inflationary pressures also rose, accelerating core inflation to 5% yoy. Early estimates show that the pickup in inflation continued in July.

The actual pace of consumer price growth approached the 5% target and was slightly lower than the forecast released in the April 2024 Inflation Report. The small deviation was mainly due to the better-than-expected food price developments. Meanwhile, core inflation’s trajectory was fully in line with April’s macroeconomic forecast.

Headline inflation, however, will not only catch up with the forecast’s April trajectory, but also slightly surpass it, reaching 8.5% at the end of the year, the NBU’s updated estimates show. The impact of inflationary factors is now pronounced, meaning that inflation can’t be expected to resume its decline before 2025.

The disinflationary effects of last year’s large harvests and favorable weather early this year are slowly dying down. At the same time, price pressures are increasing, fueled by businesses’ rising costs of labor and electricity and by the partial pass-through of the hryvnia exchange rate’s weakening to prices.

On the other hand, although business outlook has deteriorated amid growing power shortages since russia launched a new wave of attacks on the energy system, no tangible disinflationary effects from the electricity deficit have been channeled through consumer demand. Despite a slight worsening of consumer sentiment, private consumption continues to be driven by the growth in real wages in the private sector as staff shortages persist and by substantial budget expenditures, including military pay. Meantime, the producer price index in both mining and manufacturing (food production included) has surged amid power shortages. 

The government’s measures to mobilize additional revenue to maintain defense capabilities could also have an inflationary effect. In addition to the excise tax hikes already fed into the NBU’s forecasts, the government is considering other likely steps in this area. The modality of these measures is what will shape their impact on price developments.

All MPC members supported maintaining the key policy rate at 13% in July

The discussion participants agreed that with inflationary pressures rising, the inflation forecast being higher, and a partial materialization of inflationary risks being likely, such a decision by the NBU would have a cooling effect on exchange-rate and inflation expectations. This is important, given the NBU’s task to maintain the real yield on hryvnia instruments at the right level to limit the pressure on the FX market and help inflation head back to its 5% target within the forecast horizon.

Surveys of market participants and experts also reflected the reversal of the downtrend in inflation, as well as the weakening of the hryvnia’s exchange rate, one MPC member said. As soon as July, a significant number of respondents said there was no reason to cut the key policy rate further. 

Most discussion participants also agreed that keeping the key policy rate unchanged is fully in line with the NBU’s previous forward guidance, because the main prerequisite for continuing the easing cycle of interest rate policy was that risks to inflation and the FX market moderate, which hasn’t happened. Inflationary risks are much more likely to materialize in the short run than disinflationary ones, these participants said.

They said that raising taxes to cover defense expenditures is most likely to have an inflationary effect, considering that private sector wages have risen amid a lack of workers and that additional tax revenues have primarily gone towards military allowances, i.e. towards more consumption. In addition, inflationary effects from certain fiscal measures being contemplated by the authorities may contribute more to inflation compared to the baseline scenario of the macroeconomic forecast. Adverse shocks to the supply of vegetables and other raw foods are also highly likely to materialize, especially due to hot and dry weather. The NBU should therefore take into account that the actual increase in prices in 2024 may turn out greater than in the baseline scenario of the updated macroeconomic forecast.

Several discussion participants disagreed, suggesting that inflation could follow a lower trajectory. The spike in inflation in June was primarily caused by administrative measures, on which monetary policy has a limited impact, they said. On the other hand, growing power shortages, tax initiatives, migration, and the worsening of consumer sentiment may dampen consumer demand and thus restrain inflation. On top of that, Ukraine may receive more significant amounts of foreign aid, including from frozen russian assets, than currently assumed in the forecast. So, although it would be viable to halt the cycle of key policy rate cuts for now, it shouldn’t remain suspended for long, these MPC members said.

The discussion participants placed a significant focus on protecting households’ hryvnia savings against inflation. The hryvnia’s attractiveness is not a binary concept, several MPC members said. It varies gradually with changes in nominal interest rates, expectations, and investors’ approaches to reassessing the risk premium. The latter is obviously quite high as the full-scale war grinds on. To maintain the appetite for hryvnia instruments, their real yields must therefore be high enough too. This is why the NBU has since July 2023 been easing its monetary policy with caution, carefully weighing the potential effects of each move on monetary conditions, so as not to harm macrofinancial resilience. The NBU in its decisions has always heeded the risks of having expectations unanchored. These risks are now much higher than a few months ago.

One MPC member said that although real interest rates have remained positive, in June the volume and share of the banks’ hryvnia term deposits shrank for the first time in a long while, albeit only slightly. Similar developments occurred in the market for domestic government debt securities: demand for government bonds from individuals cooled somewhat, the rollover of June repayments was incomplete, and investors focused more on securities with short maturities. Simultaneously, demand for foreign currency grew, raising pressure on the hryvnia’s exchange rate and sparking certain anxiety among economic agents. As a result, the NBU had to calm the market with both FX and verbal interventions. Under such conditions, a further loosening of monetary policy may adversely affect expectations, cement the downtrend in the appetite for hryvnia assets, and trigger additional FX demand. It is therefore viable for the NBU to suspend its cycle of lowering the key policy rate and take more active measures to maintain the FX market’s sustainability.

One discussion participant said that the NBU estimated the neutral level of the real interest rate in 2016–2019 at 3%–4%. In current circumstances (with war risks running high), the key policy rate’s real level of 5%–6% is therefore not excessive. On the contrary, the gradual decline in the demand for hryvnia savings, the revival of lending, and the growth in FX demand indicate that although the key policy rate is high, monetary conditions are starting to have a stimulating effect through the deposit, credit, and exchange rate channels of monetary transmission. This means the hryvnia’s attractiveness is close to its marginal level, and that a pause in the easing of interest rate policy is fully justified.

Two other MPC members concurred that keeping the key policy rate unchanged in July is viable, given the pickup in inflation and rising concerns of economic agents, but disagreed with calling the current appeal of hryvnia assets as marginal. The cooling of appetite for hryvnia savings is an ad-hoc development, these MPC members said. It is primarily driven by psychological factors due to the temporary weakening of the hryvnia’s exchange rate and a certain deterioration in exchange rate expectations. With this in mind, the NBU has stepped up its presence in the FX market in recent weeks and clearly signaled a readiness to respond to the pullback in expectations. The NBU is definitely able to perform this task, as international reserves remain rather high and external support has been sustained. At the same time, real interest rates on hryvnia assets will continue to exceed by a fairly wide margin both the current and the expected rates of inflation, these MPC members said.

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

Most discussion participants favored maintaining the current parameters of the operational design, including the spread between the key policy rate and the rate on three-month certificates of deposit (CDs). This instrument has played an important role in restoring the attractiveness of hryvnia assets in 2023, continues to incentivize the banks to compete for term deposits, and fosters a culture of making savings in the domestic currency, they said.

The 3-pp spread between the key policy rate and the three-month CD rate is further encouraging the banks’ rivalry for depositors and the use of the available limit for such CDs to its full extent, one of these MPC members said. This tool therefore retains its effectiveness as an incentive for raising term deposits and as a means of restraining the reduction in interest rates on term deposits. Tying hryvnia liquidity up in term instruments is in turn limiting the pressure on the FX market.

A retrospective analysis shows that the narrowing of the spread between the key policy rate and the three-month CD rate has led to more significant declines in hryvnia term deposit rates than the typical response to a decrease in the weighted average rate on NBU instruments. Amid the reversal of the downtrend in inflation and elevated pressure on the FX market, such effects are best avoided. Yet this effective tool is worth keeping in the NBU’s arsenal, considering the balance of risks to inflation developments.

Another MPC member agreed with this participant, saying that returning to the conventional operating design would only be possible if inflation slowed to its 5% target. Revising the operating design’s parameters under current conditions is inconsistent with the NBU’s intention to restrain the ongoing build-up of price pressures and to shape a sustainable disinflationary trend going forward, this MPC member said. At the same time, preserving the current design of three-month CDs is quite logical amid a paused easing of interest rate policy.   

However, several MPC members said that three-month CDs are no longer so effective under current conditions, and that the NBU may consider canceling them or at least reducing the spread between the three-month CD and overnight CD rates without subverting macrofinancial stability. 

This instrument had a stronger effect when the gap between the key policy rate and deposit rates was large and the banks lacked other options to invest their term deposits, one of these MPC members said. On the other hand, the impact of transactions with three-month CDs on many banks’ pricing policies has significantly waned in recent months. There was little to no response from the banks when the spread between the key policy rate and the three-month CD rate narrowed.

Another MPC member concurred with this perspective, saying that the banks’ competition for depositors is rather lively as is, with or without three-month CDs. Some banks, for example, actually nudged their interest rates higher even as the NBU eased its interest rate policy. Such rate rises improved the banks’ deposit-raising performance. Aggressive price competition for depositors allowed private banks to win back a significant share of new term deposits from market makers. For their part, the latter have a large enough operating profitability cushion that allows them to not rush to cut deposit rates and not to lose clients going forward. This means that reserve requirements likely have a greater impact on rates, this MPC member said.

MPC members differed over the further trajectory of the key policy rate

With inflation seen to accelerate and inflation expectations being likely to deteriorate, the NBU should halt its easing cycle of the key policy rate at least until the end of 2024, most MPC members said. Some of them said they do not rule out that under certain conditions, the NBU will actually have to resort to key policy rate hikes.

By contrast, several MPC members said that after the FX market calms down and expectations stabilize, the NBU will be able to resume the cycle of key policy rate cuts before next year, especially if certain upside risks materialize, specifically those related to the confirmation of higher international aid inflows.

However, the MPC members agreed that the key policy rate’s trajectory is currently hard to project because of high uncertainty surrounding the course of the war and its impact on the economy and public finances. The NBU should be ready to continue to quickly adjust its monetary policy to changes in the balance of risks to price and FX market developments.