Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 26 April 2023

Date of the meeting: 26 April 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 key drivers of the improvement in the macrofinancial situation since the beginning of the year, the effectiveness of the NBU’s previous measures to increase the attractiveness of hryvnia instruments, and further steps to ensure exchange rate sustainability when FX restrictions are eased

During the discussion, it was noted that the macrofinancial situation continued to improve in spring. Specifically, inflation kept declining faster than expected. The slowdown was primarily facilitated by the sufficient supply of food, the saturation of the fuel market, and the fairly quick stabilization of the energy sector after russia’s massive missile attacks. An additional positive effect came from the significant improvement in FX market conditions. They got better not only due to the seasonal increase in the FX supply by farmers and the decrease in the demand for energy imports, but also because of the effectiveness of the NBU’s previous measures, including stepped-up AML/CFT efforts.

By keeping the key policy rate unchanged for a long time and by taking other measures (including the increase in reserve requirements and the announced revision of their calculation mechanism, as well as the update of the operational design of monetary policy), the NBU made hryvnia term deposits more attractive and narrowed the spread between the cash and official exchange rates of the hryvnia. This contributed to a noticeable improvement in exchange-rate and inflation expectations, fortified the balance between FX supply and demand, and enabled a significant reduction in FX interventions by the NBU. Thanks to sustained significant inflows of external support, Ukraine’s international reserves rose to an 11-year high of almost USD 32 billion in early April. State budget tax revenues also increased, as did the volume of domestic public borrowing. As a result, budget expenditures have been completely covered since the start of 2023 without resorting to monetary financing. All of the above reinforced the NBU’s capability to ensure exchange rate sustainability and a further easing of inflation.

However, tentative positive dynamics in certain macroeconomic indicators in recent months should not fuel excessive optimism. Inflation pressure remains significant, while inflation expectations are still close to their highest levels seen during previous crisis episodes. Multiple war-related risks persist as the full-scale war grinds on. If materialized, they may lead to adverse effects – such as elevated pressure on the exchange rate and international reserves, and an unanchoring of expectations – threatening to reverse the downward-sloping trend in inflation. The NBU should stop such a scenario from taking place. 

Nine MPC members called for maintaining the key policy rate at 25% in April

Key policy rate decisions should be considered solely in the context of the exchange rate policy strategy and the expected easing of FX restrictions, these MPC members said. Further price dynamics in Ukraine will depend significantly on the security situation and the NBU’s ability to maintain exchange rate sustainability. Uncertainty around future developments on the frontlines remains high, and exchange rate sustainability is largely being ensured by the growing attractiveness of hryvnia savings, and tight FX restrictions. The effectiveness of the latter wanes over time, while their tendency to restrain business activity intensifies. The easing of the most burdensome FX restrictions is therefore becoming increasingly relevant. Successful completion of this task, without causing shocks to the economy and the FX market, will require making sure that hryvnia savings remain highly attractive.

The NBU’s previous measures, including increased reserve requirements and the introduction of a new operational design, have proved effective in helping raise hryvnia deposits’ interest rates and maturity. Specifically, the weighted average interest rate on new hryvnia retail term deposits rose by 0.6% pp in March. The central bank succeeded in reversing the downtrend in term deposits as a share of all retail deposits: in January–March 2023, this ratio expanded by 2.7 pp, to 33.6%. According to the NBU’s Bank Lending Survey, financial institutions expect the uptrend in term deposits to persist into the next 12 months. For the NBU’s measures to continue to have an impact, it is necessary to pursue a consistent monetary policy aimed at ensuring the investment appeal of hryvnia savings and immobilizing current account funds by channeling them into term instruments. Such a strategy will enable the NBU to move towards a careful easing of FX restrictions without subjecting macrofinancial sustainability to shocks.

The simultaneous easing of FX restrictions and reduction of the key policy rate amid unprecedented current account balances may undermine macrofinancial sustainability, one MPC member said. Proceeding step-by-step is therefore an important prerequisite for keeping the situation under control. The shift to a loosening of FX restrictions should take place in conditions of the rising attractiveness of hryvnia savings, this MPC member said. Although the administrative controls imposed at the onset of the full-scale war have helped ensure macrofinancial sustainability, they have also created an overrated estimate of the economy’s real strength. Despite the emergence of certain encouraging trends, it is important to keep in mind that the economy remains rather weak and dependent on external support. There is also the risk of an unanchoring of expectations that play an important role in exchange-rate and price dynamics.

Another MPC member supported this opinion. The NBU should, especially during the full-scale war, comprehensively and conservatively assess both domestic and external circumstances, leaving enough maneuverability room for response if things follow a negative scenario, this MPC member said. Because key policy rate decisions have a significant monetary transmission lag, a cut to the key policy rate and a resulting decrease in the attractiveness of hryvnia savings will weaken the NBU’s maneuverability. From this perspective, FX restrictions make room for a more rapid and targeted response. At the initial stage of the loosening of administrative controls, it is wise to keep the key policy rate in the risk management toolbox.

Another participant in the discussion concurred with this rationale. This MPC member brought up the experience of 2017, when choices had to be made amid a trade-off between relaxing FX restrictions and lowering the key policy rate. That experience suggests that the easing of restrictions should precede the reduction of the key policy rate. On top of that, premature cuts to the key policy rate could result in inflation getting stuck at high levels.

Favorable conditions are emerging for a further easing of FX restrictions "from a position of strength," another MPC member said. This approach will minimize pressure on the FX market. The emergence of such prerequisites has been made possible by the improvement in exchange-rate and inflation expectations and FX market conditions in recent months, the rising attractiveness of hryvnia-denominated savings, and the accumulation of a comfortable amount of international reserves.

Risks of the interest rate policy being excessively hawkish on the one hand and prematurely dovish on the other are currently asymmetric, this participant said. The risks of the former scenario are minimal, as inflation remains rather high over the forecast horizon, and lending is primarily restrained by significant uncertainty and a wartime risk premium and is mainly sustained by government programs with preferential interest rates. The high key policy rate is therefore helping maintain exchange rate sustainability and curb inflation and is currently not the main impediment to revitalizing economic activity. A reduction of the key policy rate will not bring about a significant increase in lending. On the other hand, a premature easing of monetary policy can have rather tangible adverse effects. A decrease in the investment appeal of hryvnia instruments amid exceptionally high current account balances will threaten to put more pressure on the exchange rate, potentially triggering a spike in inflation and a worsening of expectations. As a result, currency liberalization will have to be postponed, and the cycle of key policy rate cuts will have to be suspended or even reversed, which will only undermine confidence in the NBU’s policy and put a drag on economic recovery.

The NBU should continue to factor into its decisions the considerable uncertainty surrounding the further course of military operations, several MPC members said. Specifically, the core assumption in the NBU’s forecast is that security risks will start to moderate significantly from early 2024.  However, one cannot rule out that it will take longer to conduct the offensive, and that it will entail a number of other consequences for the economy. Those may include a longer life of the high risk premium, a prolongation of supply chain disruptions, and a worsening of exchange-rate and inflation expectations, with the result that the hryvnia liquidity overhang spills over into the FX market. Other complications are also likely, such as a complete shutdown of the grain corridor and disruptions to Ukrainian exports across the western border. Such problems may restrain FX inflows to the country. Underestimating these risks could undermine exchange rate sustainability and lead to a significant worsening of macroeconomic developments.

With uncertainty running high, it is important to refrain from getting people’s hopes up about the sustainability of the economy and from making quick and easy decisions that can do more harm than good in the long run, several MPC members said.

Two members of the MPC suggested cutting the key policy rate to 24% in April

Better macroeconomic conditions, as well as the significant improvement in the inflation forecast to a level below 15% at the end of the year, even considering the risks, are a strong argument for starting to gradually reduce the key policy rate as early as April, these discussion participants said. As a result of the further pullback in inflation and improvement of inflation expectations, the real yield on hryvnia instruments will go up, sustaining their attractiveness even if a moderate decrease in nominal interest rates occurs. What is more, a faster start to the lowering of the key policy rate will make it more gradual than proposed in the baseline scenario of the macroeconomic forecast, mitigating threats to financial sustainability.

Pro-inflation risks on the monetary policy horizon are overestimated, one MPC member said. Ukraine has successfully overcome the energy crisis. Over time, price pressure from businesses’ costs of insuring uninterrupted operations amid power outages will die down. Businesses’ outlook on the workload of production capacities is improving. For the first time since the war broke out, businesses have begun to expect the production of goods and services to increase. Businesses are also expecting significant inflows of productive foreign capital during post-war recovery. They will contribute to the growth in potential GDP, and thus the expansion of the output of goods and services, without causing significant inflationary pressure. Such inflows will also be a fundamental factor in expanding the supply of foreign currency on the market.

Even supply chain disruptions in food exports can contribute to disinflation processes in the domestic market for foodstuffs, this MPC member said. With this in mind, the NBU should not procrastinate with launching a key policy rate reduction cycle, because when the need for more decisive steps arises, it will be more difficult to implement them in short order without adversely affecting financial sustainability, this MPC member said.

Cutting the key policy rate by 1 pp in April poses no risks, another MPC member said. With the operational design having been recently changed, the current weighted average interest rate on certificates of deposit already stands at about 21%. This is because most of the banks’ April transactions to place free liquidity were carried out at a reduced rate of 20% on overnight certificates of deposit, and only part of the liquidity was placed at the current key policy rate of 25% into three-month certificates of deposit. Their availability to the banks depends on how successfully they raise term deposits.

As a result, a slight decrease in the key policy rate will not have an adverse effect on macrofinancial sustainability, but will only bring the key policy rate’s nominal level closer to the real one, at which the majority of the banks have already been making regular transactions, this MPC member said. At the same time, even under such a scenario, the key policy rate will remain high, and the NBU will have sufficient wiggle room to maintain the maneuverability of inflation processes.

Meanwhile, another MPC member suggested that along with the reduction of the key policy rate, the weighted average rate of NBU transactions will also decline, as the key policy rate is tied to both the rate on certificates of deposit and the rate on refinancing loans. Accordingly, a reduction in the key policy rate will lead to a real softening of monetary policy. Furthermore, it will weaken the performance of the recently updated operational design, leading to more monetary easing, which this MPC member said is premature and will increase risks to macrofinancial sustainability.

Going forward, although the MPC members differ on the pace and timing of a shift to key policy rate cuts, all MPC members expect the fairly tight monetary conditions to continue to exist

Most of the participants in the discussion believe that by the end of 2023, the NBU can reduce the key policy rate to 21%. They mostly agree that Q4 is an optimal timeframe to launch a key policy rate reduction cycle. Such timing is dictated by the prioritized need to relax part of the FX restrictions. At the initial stage of currency liberalization, the fixed exchange rate will be an important tool in managing expectations and risks. As soon as the NBU sees enough evidence that exchange-rate and inflation processes are controllable amid loosened administrative restrictions, it will be able to commence a cycle of key policy rate cuts without creating threats to macrofinancial sustainability.

These MPC members also agreed that the potential for lowering the key policy rate on the monetary policy horizon is considerably restrained by the consequences of the war. Ukraine will spend a significantly amount of time restoring its production capacities and exports and waiting for its forced migrants to return. Ukraine’s import needs during the recovery will be significant. Under such conditions, maintaining exchange rate sustainability will require the NBU to pursue a consistent policy to ensure that hryvnia savings are highly attractive and that pressure on international reserves eases. Thanks to the expected amount of international aid, which will help close the current account deficit, the NBU will be able to continue lowering the key policy rate in 2024, but this process will be rather slow. By late 2024, the key policy rate will have been reduced to 18%, most MPC members said.

In the meantime, two discussion participants offered a different vision of the key policy rate’s future trajectory. Specifically, the faster-than-expected decline in inflation will enable the NBU to cut the key policy rate to 18% by the end of this year and to 14% in 2024, one of these MPC members said. Prerequisites exist for lowering the rate to 20% at the end of this year and to 16% next year, another MPC member said. Taking into account the expected inflation rate, such a level of the key policy rate will keep monetary conditions sufficiently rigid to maintain macrofinancial sustainability and will accelerate the economic recovery, this MPC member said.

Marking forecasts for 2024–2025 is extremely difficult due to high uncertainty around the war, several MPC members said. This argument also applies to the forecast trajectory of the key policy rate, which is primarily designed to ensure the necessary monetary conditions to maintain exchange rate sustainability, improve expectations, and steadily reduce inflation. The NBU should be ready to adjust the time and pace of changes in the key policy rate in view of FX market developments, inflationary dynamics, the continuity of international support, and the effectiveness of measures to make hryvnia instruments attractive.