Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 25 October 2023

Meeting date: 25 October 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 the sustainability of the downtrend in inflation, the effects of previous steps to ease interest rate policy, the transition to managed flexibility of the exchange rate, the updated macroeconomic forecast, and changes to the balance of risks. The meeting focused specifically on modernizing the operational design of monetary policy and taking further measures to maintain exchange rate sustainability and the moderate rate of inflation.

Headline inflation slowed to 7.1% yoy in September, while core inflation decelerated to 8.4% yoy, the MPC members said during the discussion. Both indicators fell to single-digit levels for the first time since the onset of the full-scale war. By NBU estimates, the pullback in inflation continued in October. Such price dynamics were driven by a number of factors, some of which are temporary. Good harvests and the ensuing increase in the supply of food products contributed to a significant reduction in food inflation. The fixing of tariffs for some utilities restrained the growth in administrative prices. The NBU’s measures to maintain the sustainability of the FX market made it possible to reduce underlying inflationary pressures. This inhibited price increases for a wide range of goods with a large share of imports in production costs and helped improve expectations.

The FX market situation remained sustainable after the NBU made the transition to managed flexibility of the exchange rate. Demand for foreign currency increased expectedly within two days from the transition. However, the NBU’s FX and verbal interventions minimized exchange rate fluctuations, and demand stabilized. The market has been adjusting to new conditions: the exchange rate is fluctuating moderately in either direction, the volumes and balances of client transactions are slowly returning to previous months’ levels, and the NBU is winding its interventions down. Several weeks into the new exchange rate regime, the hryvnia actually strengthened somewhat, in both the interbank and cash markets. Preserving the sustainability of the FX market will have a positive effect on exchange-rate and inflation expectations.

Apart from interventions, the NBU’s actions to maintain the sufficient attractiveness of hryvnia-denominated instruments were an important factor in safeguarding the FX market’s sustainability. As expected, previous steps to reduce the key policy rate led to a decline in rates on hryvnia deposits and domestic government debt securities. At the same time, transactions with limited three-month certificates of deposit (CDs) and the reserve requirement mechanism fueled interest rate competition by the banks for retail term deposits even as the NBU eased its interest rate policy. Thanks to this, nominal interest rates on term deposits and domestic government debt securities decreased relatively slowly. In real terms, they even edged higher amid improved inflation expectations. Hryvnia instruments therefore continued to protect savings against inflation-driven loss of value, taking into account both current and expected inflation. The prospect of a further reduction in nominal rates only stimulated the demand for hryvnia assets. As a result, retail term deposits rose although exchange rate expectations got slightly worse ahead of the exchange rate regime change. Depositors also retained their appetite for domestic government debt securities. All of this restrained the pressure on the FX market.

However, wartime risks to exchange rate sustainability, and hence to price dynamics, persist.  The suspension of the grain corridor and significant damage to port infrastructure have already reduced FX inflows into Ukraine. By continuing to subvert Ukraine’s logistical routes, russia could do even more damage to Ukrainian exports. The problem with delays in the repatriation of FX earnings by some exporters has also worsened. What is more, the regularity of international aid inflows has weakened in recent months. Although these risks have not yet fully materialized, they cannot be ignored when making monetary decisions. In view of this, it is important to continue to maintain the attractiveness of hryvnia instruments in order to minimize risks to the FX market and price dynamics, the MPC members said.

Ten MPC members spoke in favor of keeping interest rates unchanged for all of the NBU’s transactions with the banks

At this time, keeping rates on the NBU’s transactions with the banks unchanged conforms with the need to maintain the attractiveness of hryvnia instruments, the discussion participants said. This is important for ensuring moderate inflation and exchange rate sustainability over the forecast horizon. Such a policy will restrain the pressure on the FX market and international reserves as the FX market adjusts to a gradual increase in the exchange rate’s flexibility and the NBU implements its plan to further ease the FX restrictions that exert the most pain on businesses.

The NBU should take into account that there is almost no room left to further alleviate inflationary pressure, one MPC member said. The plunge in inflation in recent months has largely been due to temporary factors like ample harvests. It will be a few more months before the impact of these disinflationary forces begins to wear out. In addition, it is worth taking into account the persistence of the pressure on business costs due to the revision of assumptions about the longevity of security risks and wage increases (driven specifically by the lack of suitable personnel), as well as a possible acceleration of the growth in administered prices. The inflation forecast for next year has actually been slightly revised upwards. Inflation will remain above the target range throughout 2024. This limits the scope for loosening the interest rate policy.

An acceleration of inflation can stop or even reverse the trend towards more upbeat inflation expectations, something that can adversely affect the attractiveness of hryvnia savings, another participant in the discussion said. The NBU should take into account the significant current account balances of households and businesses, which will only increase as expected liquidity infusions arrive through the budget payments channel. A sharp loosening of the interest rate policy may lead to significant decreases in rates on hryvnia instruments. If these rates fail to cover the pace of inflation and the hryvnia’s depreciation anticipated by economic agents, the speed with which this hryvnia overhang spills over into the FX market will accelerate.

Another MPC member agreed with this participant, saying that the NBU should account for the possibility of a stronger response by bank rates to the reduction of the key policy rate amid a significant liquidity surplus. The banks’ response to the NBU’s launch of the cycle of key policy rate cuts was rather powerful, this MPC member said. Specifically, rates on hryvnia term deposits of nonfinancial corporations dropped by 1.1 pp in August already, and by another 0.9 pp in September. Thanks to additional steps by the NBU, the weighted average interest rate on hryvnia retail term deposits declined more moderately in August (by 0.6 pp) and almost held steady in September. At the same time, the dynamics of the Ukrainian Index of Retail Deposit Rates indicate an acceleration of the decrease in deposit rates in October, which poses risks to the hryvnia’s attractiveness. This limits the scope for the NBU to lower rates.

As per the Strategy for Easing FX Restrictions, Transitioning to Greater Flexibility of the Exchange Rate, and Returning to Inflation Targeting (hereinafter referred to as the “Strategy”), which prioritizes progress towards the specified goals, favorable macroeconomic trends should primarily be perceived as a signal for easing FX restrictions further instead of as a trigger for making more aggressive cuts to the key policy rate, another participant in the discussion reminded everyone. Further efforts to increase exchange rate flexibility and take liberalization measures will gradually shore up the economy’s resilience. However, to successfully implement these measures and preserve exchange rate sustainability, it is necessary to maintain the attractiveness of the hryvnia at the right level. This also puts relevant restrictions on the further easing of the NBU’s interest rate policy.

One MPC member proposed to keep the rate for overnight CDs unchanged, but to lower the rates on three-month CDs and refinancing loans

From this MPC member’s perspective, there is potential to reduce the interest rate on three-month CDs. With a 3 pp spread between the rates on three-month and overnight CDs, the banks will continue to have adequate incentives to compete for depositors and build up the portfolio of new retail term deposits, this participant estimates. The banks will therefore be in no rush to cut rates on term deposits.

In addition, it is advisable to slightly lower the rates on refinancing loans, which are currently not in demand due to a significant liquidity surplus, this MPC member said. The narrowing of the interest rate corridor for standing facilities and of the interest rate spread between three-month and overnight CDs will help keep short-term interbank rates closer to the key policy rate.

All MPC members supported the update of the operational design of monetary policy as per the floor system

The discussion participants agreed that the transition to a floor-system-based operational design will enable the NBU to more effectively meet its goals amid a significant structural surplus of liquidity. Specifically, the updated operational design will ensure that the bulk of transactions to regulate the banking system’s liquidity is carried out at the key policy rate. The key policy rate’s impact on money market conditions will therefore increase, and the rate will regain its status as the main reference point for short-term market rates. At the same time, the movement of short-term interbank rates towards the key policy rate will make it easier for market players to understand current monetary conditions and anticipated changes in monetary policy. By strengthening the signaling role of the key policy rate, the NBU will be better able to influence the expectations of economic agents, and thus the cost of not only short-term, but also medium- and long-term funding, as well as exchange rate dynamics. Such influence and related changes in the expectations and incentives of economic agents will shape their consumption and investment behavior. This will help the NBU achieve its goals of ensuring price and financial stability to guarantee sustainable economic recovery.

Another MPC member said that the floor system, which is often associated with the scarce reserves system, loses its effectiveness when the structural surplus of liquidity in the banking system grows rapidly.  This problem is made worse when the increase in liquidity is driven by factors independent of the central bank (CB), such as government spending, capital inflows, or international aid. Under such conditions, it becomes operationally difficult for the CB to accurately forecast the amount of liquidity and maintain it at a relatively balanced, neutral level by making transactions with banks at the key policy rate. Without this, the rates for short-term transactions between banks tend to gravitate towards rates on standing facilities for liquidity withdrawals (like overnight CDs in Ukraine) instead of towards the CB’s key policy rate.

Massive quantitative easing programs that were launched after the global financial crisis, as well as large-scale fiscal and monetary stimulus during the Covid-19 crisis, led to a surge in excess liquidity in both developed and emerging markets. This contributed to the spread of floor-system-based operational designs.

A similar situation is taking place in Ukraine, where short-term interbank rates have in recent years de facto stood close to the overnight CDs rate due to the expansion of the liquidity surplus. On top of that, these transactions are precisely what have made up the majority of liquidity-regulating measures since russia launched its full-scale invasion of Ukraine. Given the need to finance Ukraine’s considerable budget deficit by international aid, the banking system’s liquidity will continue to grow over the forecast horizon. It should therefore be expected that the rates for short-term transactions between the banks will continue to approach the overnight CDs rate. As a result, the shift to the floor system is a fully justified step from the perspective of streamlining the operational design to reinforce the role of the key policy rate as a monetary instrument. Furthermore, the resumption of the use of the key policy rate to make the bulk of liquidity withdrawal transactions is stipulated by the Strategy.

Another participant said that the Strategy also specifies that the NBU will adjust the operational design of monetary policy to strengthen monetary transmission and ensure the right level of attractiveness of hryvnia instruments.

In this context, the MPC members agreed that the new operational design will continue to incentivize the banks to compete for retail term deposits. With this in mind, the limited three-month CDs conditioned on the banks’ success in raising term deposits should remain an important feature of the new design. The NBU will use the limited three-month CDs until at least April 2024, as it planned when it introduced them.

Another discussant highlighted a different benefit of modernizing the operational design. Under the floor system, the key policy rate will determine the rate for the core, regular transactions with overnight CDs instead of for limited three-month CDs, which are auxiliary and potentially temporary. This is important for reducing uncertainty, better understanding the forecast trajectory of the key policy rate, and thus improving the performance of the NBU’s interest rate policy.

Another MPC member said that the operational design update is also important from the standpoint of increasing the efficiency of the monetary policy decision-making process and the communication of these decisions to the public. In Ukraine, members of the public traditionally focus on and discuss the de jure key policy rate, as it is legally the main interest rate. However, important changes to monetary conditions caused by movements in the overnight CDs rate, at which the bulk of transactions de facto take place, are sometimes left out of the spotlight. In April 2023, for instance, the overnight CDs rate was cut to 20% from 23% when unconventional features were being introduced into the operational design of monetary policy. At the time, 100% of bank liquidity withdrawal transactions were made at that rate. However, that step did not command sufficient attention, because the de jure key policy rate remained at 25%.

The MPC members said the prerequisites have been met for making a rate cut in December, but there is difference of opinion in the MPC about the size of such a step

All MPC members are seeing the possibility to ease the interest rate policy further, provided that market participants can successfully adjust to the new FX regime and that there is no noticeable deterioration in the balance of risks. Most MPC members expect that the key policy rate will be cut by 1 pp, down to 15%, in December, and that other NBU rates for transactions with the banks will be adjusted accordingly. In contrast, several MPC members said that prerequisites have already been met for a more significant reduction – by 2 pp – in the key policy rate and other rates for the NBU’s transactions with the banks.

At the same time, the discussion participants generally agreed that the potential for a loosening of interest rate policy in 2024 appears limited at this time because of FX liberalization plans and an anticipated acceleration of inflation next year. The sufficient attractiveness of hryvnia instruments will remain one of the important prerequisites for preserving the sustainability of the FX market, the MPC members said. To this end, the NBU will have to maintain sufficiently high rates for transactions with the banks.

However, several MPC members suggested that the NBU may revise the forecast of the key policy rate in the new forecast cycle in January if positive shifts occur in the balance of risks to exchange rate sustainability and price dynamics. The grounds for such a revision can include confirmation of the regularity of international aid, improvement of expectations, and a better than currently expected balance of supply and demand in the FX market. Such developments will make it possible to move towards a point where interest rates can be lowered further.