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

Date of the meeting: 25 January 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 prerequisites, risks, and further measures of avoiding the monetary financing of the budget deficit, enhancing the FX market’s resilience, and reducing inflation.

Inflationary pressure is showing signs of stabilizing, albeit at a high level, the discussion participants said. Inflation, which in recent months remained almost unchanged in annual terms, ended the year at 26.6%. The seasonally adjusted monthly change in consumer prices also fluctuated in a sideways range of 25%–30% yoy in recent months. An important factor in the stabilization of inflationary pressure was the increase in the supply of food products and the liberation of previously occupied territory, including parts of the Kherson oblast. The removal of supply chain disruptions in liberated cities and towns contributed to the reduction of prices in these regions.

The fixed official exchange rate, supported by administrative restrictions and FX interventions by the NBU, became the main anchor for stabilizing expectations and price dynamics. The measures taken by the NBU, both to calibrate FX restrictions and to create additional opportunities to protect savings, also contributed to the strengthening of the hryvnia in the FX market’s cash segment at the end of the year. Among other things, this made it possible to stabilize inflationary and exchange rate expectations. The FX market remained stable even as russia scaled up its terrorist attacks.

Inflation was also restrained to some extent by the demand factor as russia launched missile strikes against energy infrastructure. This was in part due to the shift in consumer spending towards goods that are necessary to get through the heating season amid frequent blackouts and that make up a large portion of the CPI. The growth in prices continued to be slowed by factors such as alleviating supply chain disruptions and keeping utility prices fixed.

Consumer price growth is expected to moderate in 2023 due to the tight monetary policy, lower global inflation, and weaker demand. However, risks to the inflation forecast remain elevated, primarily due to the possibility that security risks may persist longer than anticipated as the enemy destroys more infrastructure and production capacities while supply chain disruptions and power shortages intensify.

Specifically, the grain corridor is running a permanent risk of being disrupted, and missile terror from russia can cause more significant gaps in the energy system. All of this is threatening to reduce the supply of certain goods, increase production costs further, and decrease businesses’ revenues, including FX proceeds. These conditions may result in budget revenues being insufficient and in additional expenditures to sustain the defense capability and social spending. Among other things, this is driving a moderate risk that the monetary financing of the budget may return after having been suspended, as planned, at beginning of 2023. International aid and domestic debt market borrowing should be sufficient to avoid this scenario, but the regularity of this funding remains at risk.

The early signs of stabilization of inflation expectations are not giving cause for excessive optimism either. The current levels of inflation expectations of certain groups of respondents are close to the highest values seen in previous crisis episodes. The medium-term expectations of some groups of respondents have recently continued to worsen. With exchange rate expectations remaining elevated, and with the liquidity overhang being significant, the financial system continues to be highly sensitive to ad-hoc factors. Therefore, taking into account the revision of the assumption about the duration of security risks and russia’s terrorist actions, a threat still exists that exchange rate pressure may rise, that inflation may settle at a high level, or that the inflation spiral may continue to unfold.

Considering the above, the MPC members, for the fifth time running, unanimously spoke in favor of keeping the key policy rate at 25%.

Under current conditions, maintaining the key policy rate at 25% is the optimal solution from the perspective of ensuring exchange rate stability and the return of inflation and expectations to a steady downward trajectory, the MPC members said. This decision takes into account the balance of risks over the forecast horizon, including the uncertainty and challenges that may emerge from a possible escalation of hostilities.

Keeping the key policy rate unchanged is also consistent with the NBU’s previous communications and is in line with market expectations. This decision correlates fully with the commitment stipulated by the memorandum with the IMF, specifically that the NBU will continue to pursue a monetary policy that eases price pressure and makes hryvnia assets more attractive, one MPC member said. 

As with previous MPC meetings, most participants in the discussion do not see any prerequisites for cutting the key policy rate in 2023.

The majority of MPC members believe that the baseline forecast of the key policy rate is realistic, as is the rate’s maintenance at up to 25%, at least until the end of Q1 2024. From their perspective, maintaining the rate at a high level will help strengthen the monetary transmission and achieve the NBU’s goals of increasing the investment appeal of hryvnia assets and improving the term structure of deposits in the banking system.

It is too early to give any signals of a quicker easing of monetary policy, several discussion participants said. In their opinion, inflation risks remain shifted upwards. If these risks materialize, there will be a need for an additional tightening of monetary policy, in which case a premature announcement of a possible softening of the monetary stance may undermine market participants’ confidence in the NBU’s decisions and lead to a deterioration of expectations. What is more, premature signals about a loosening of monetary policy may restrain the monetary transmission mechanism, and the sensitivity of the financial system to ad-hoc factors may therefore stay elevated.

Even under the current key policy rate forecast, inflation will remain above its target range at least until the end of 2025, in particular due to the need to adjust utility prices after security risks moderate, another MPC member said. Such a long stay of inflation at high levels, even as nonmonetary factors continue to exert significant influence, will increase the threat of unanchoring of inflationary expectations. The issue of loosening the monetary policy stance and communicating such decisions should therefore be approached very carefully, so as not to shake the trust in the NBU’s actions.

In contrast, several discussion participants believe that the probability of a significant tightening of monetary policy is low. Furthermore, from their perspective, a cycle of key policy rate cuts may begin somewhat earlier than the updated forecast suggests. Specifically, price pressure this year may turn out to be lower than currently expected, in part due to a greater-than-expected weakening of consumer demand, a faster slowdown in global inflation, and the maintenance of utility prices for households at a low level, one of these MPC members said.

The discussion participants supported further measures to step up the banks’ competition for term deposits, including the next stage of increasing the reserve requirements (RR).

The NBU’s previous steps to fortify the monetary transmission, including the December decision to tighten the RR for current accounts and demand deposits, underpinned the further growth in the interest rates on hryvnia deposits, the discussion participants said. The growth trajectory of the rates on hryvnia retail term deposits, weighted by the volume of new deposits raised via such rates, is staying close to the model trajectory of the pre-war response to changes in the key policy rate.

Meanwhile, the growth in the Ukrainian Index of Retail Deposit Rates, which is not volume-weighted, decelerated in October–December. This shows that the volume of newly raised term deposits is rising primarily due to the banks that are offering depositors better conditions, according to one discussion participant. Therefore, the interest rate on hryvnia assets remains important for making savings decisions, even as the full-scale war grinds on.

In response to the rise in interest rates, the share of term deposits in the total volume of new hryvnia retail deposits has been slowly expanding and has exceeded its pre-war level. At the same time, large banks continue to abuse the noncompetitive advantages of high liquidity and are in no rush to join the fight for depositors’ money. This is limiting the impact of rate hikes on the conversion of households’ and businesses’ funds into term instruments. Specifically, term deposits that were made before the full-scale war broke out are ending up in current accounts after maturity, as the interest rates are still lacking a term premium that would be sufficient to beat the increased advantages of liquidity and the wartime aversion to risk. As a result, the share of term deposits in the stock of retail hryvnia deposits of the banks continues to decrease. For its part, the large amount of money in current  accounts amid rather high exchange rate expectations is increasing the FX market’s vulnerability to spontaneous factors and posing additional risks to the controllability of exchange rate dynamics. Evidence of this is the pressure on the hryvnia exchange rate in late 2022 through early 2023, which has been growing since the government made significant budget payments. Further decisive steps by the NBU are therefore needed in order to eliminate the threats posed by the structural surplus of liquidity.

The MPC members unanimously spoke in favor of the second stage of raising the RR, which was announced in December. In particular, they supported raising the RR by 5 pp for the demand deposits and current accounts of legal entities and individuals, from 11 February.

Furthermore, the MPC members supported an additional RR increase of 10 pp for hryvnia and FX retail demand deposits and current  accounts, starting 11 March. However, it was decided not to extend the benchmark domestic government debt securities coverage mechanism to this part of reserves.

This decision takes into account the need to reduce the liquidity surplus without creating threats to the stability of the domestic market for public borrowing, one MPC member said. The current RR decisions are designed in a way that will preserve the banks’ ability to actively participate in government auctions to place domestic government debt securities even if part of the liquidity is withdrawn, this discussion participant said. This approach to liquidity regulation will help avoid a resumption of the monetary financing of the budget deficit, which is at least as important, another MPC member said. 

The measures taken to immobilize liquidity may not be sufficient, as it is constantly being fueled by the conversion of FX inflows from foreign partners to cover high budget expenditures, several MPC members said. For its part, the liquidity raised by the government through the sale of domestic government debt securities is returning to the banking system rather quickly. Significant interventions by the NBU are only partially absorbing this liquidity. As a result, it is necessary to develop additional steps to sterilize the liquidity surplus and reinforce the monetary transmission mechanism.

With this in mind, the MPC members discussed the possibility of introducing additional tools to protect hryvnia retail and corporate deposits from inflation. The discussion participants also looked into various options for optimizing the operational design of monetary policy that have the potential to make hryvnia assets more attractive, taking into account the NBU’s other measures. The MPC members agreed to continue to discuss these steps after talking them through with the IMF and making additional assessments of their potential impact, including on domestic debt market conditions.

The MPC members also concurred that all the measures that the NBU is taking today to stimulate hryvnia term deposits and keep the FX market stable should create prerequisites for easing the FX market restrictions that are causing the most critical distortions in this market and having the most adverse effect on business activity.