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

Meeting date: 26 July 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 favorable macrofinancial trends of recent months, the effectiveness of the NBU’s previous measures to increase the attractiveness of hryvnia assets, and the sufficiency of these prerequisites for a faster-than-previously-anticipated reduction in the key policy rate

Inflation has been slowing faster than the NBU expected, the MPC members said. In June, it fell to 12.8% yoy. In H1 overall, inflation more than halved. Core inflation also decelerated significantly, to 13.7%. In addition, the exchange-rate and inflation expectations of most respondents (except for households in May–June) have improved significantly in recent months. Based on these and other factors, the NBU has significantly improved its forecast of price developments. At the end of this year, inflation is expected to run at 10.6%, down from 14.8% in the previous macro forecast. Inflation will continue to decline: to 8.5% in 2024 and to 6% in 2025.

The NBU’s measures have been an important factor in making possible the faster-than-expected pullback in inflation. Those included keeping the key policy rate high, introducing an unconventional operational design of monetary policy, tightening the reserve requirements for banks, as well as AML/CFT and currency supervision measures. These efforts have helped make hryvnia-denominated assets more attractive and steadily improve the FX market situation. 

Some 95% of the banks surveyed by the NBU have raised their rates on hryvnia deposits. Even in June, after the NBU announced the possibility of a quicker shift to a key policy rate reduction cycle, rates on retail deposits of various maturities continued to rise. As a result, the weighted average interest rate on new hryvnia retail term deposits reached 14.2%. 

This brought about an improvement in the term structure of deposits that has been ongoing for the second straight quarter. In the first six months of 2023, hryvnia retail term deposits grew in volume by 23.3%, while their share in the total portfolio expanded by 4.3 pp. At the same time, demand for foreign currency declined, as evidenced, among other things, by the significant strengthening of the hryvnia in the market’s cash segment and by the sustained proximity of the cash exchange rate to the official one.

Significant support for macrofinancial stability came from international partners. Since the beginning of the year, Ukraine has received about USD 27 billion in loans and grants. As a result, international reserves are at an all-time high (almost USD 39 billion at the start of July), and the NBU will continue to be able to balance out the FX market through interventions. In addition, the latter also shrank significantly (to USD 5.1 billion in Q2 from USD 7.2 billion in Q1) thanks to both the NBU’s efforts and the economy’s overall adjustment to new wartime challenges. Regular disbursements of international aid have also made it possible to cover the significant wartime budget deficit without resorting to monetary financing. Maintaining the adequacy and timeliness of international aid inflows is important for ensuring macrofinancial stability going forward.

Coupled with improved expectations amid further growth in nominal market interest rates, the faster-than-anticipated easing of inflation has helped speed up the increase in the real yield on hryvnia instruments. Meanwhile, the more significant increase in international reserves, as well as the expansion of hryvnia term deposits’ share in the banking system, indicates an easing of risks to exchange rate sustainability and hence to disinflationary developments. With this in mind, the NBU can launch a cycle of key policy rate cuts earlier than the previous forecast predicted. 

Five members of the MPC suggested cutting the key policy rate to 22% in July

The wide gap between actual inflation and the key policy rate allows room for a more substantial first step than previously anticipated, these MPC members said. They said that such a cut will not only meet the general expectations of the market and consumers, but will also send a positive signal of greater willingness to support the economic recovery. At the same time, slower inflation and better expectations will make it possible to keep hryvnia assets attractive enough even as a nominal reduction of the key policy rate occurs. Therefore, these MPC members said, such a decision will be fully compatible with the recently approved Strategy to Ease FX Restrictions, Transition to Greater Flexibility of the Exchange Rate, and Return to Inflation Targeting (hereinafter the "Strategy").

A 1–2-pp cut to the key policy rate was expected after the publication of the previous Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee, one of these MPC members said. Since the June meeting, however, the macroeconomic situation has continued to improve at a faster pace than projected. This is a sufficient condition for a more decisive cut. A 3-pp cut appears well-founded: it is a logical response to the strengthening of favorable macroeconomic trends and the significant positive revision of the macroeconomic forecast. A reduction of that size will therefore come as no surprise for the market and the expert community, this MPC member said. 

There is no reason to be afraid of making such a bold first move, another MPC member said. A 3-pp cut to the key policy rate will not lead to a sharp decrease in the return on hryvnia deposits in the banking market, this MPC member said. First, interest rates on retail deposits are as a rule rather sticky. What is more, at many banks, these rates are still significantly lower than the key policy rate, meaning there is enough space to raise them further. Second, sufficiently active competition for depositors among small and medium-sized banks will restrain the decline in market rates. 

The decision on the key policy rate should be considered in conjunction with the NBU’s exchange rate policy, another MPC member said. The official exchange rate currently remains fixed. The closest to it is the cash rate, which is the primary anchor for households’ expectations. Under such conditions, with the risk of depreciation being insignificant, hryvnia assets will remain sufficiently attractive even after the key policy rate is reduced by 3 pp.

Three MPC members spoke in favor of a more significant reduction in the key policy rate in July: two of them said it should be slashed to 20%, one suggested a cut to 21%

These MPC members are convinced that the faster-than-expected improvement in the macroeconomic situation creates opportunities for the NBU to support the economic recovery by easing its interest-rate policy more quickly than previously discussed. The NBU’s actions up until now have been cautious, and its macroeconomic forecasts are based on rather conservative assumptions, these MPC members said. Evidence of this, among other things, is that inflation has been persistently staying below its forecast trajectory and that the NBU’s forecast has once again been considerably improved. 

The sustainability of the disinflationary trend and the level of the economy’s adjustment to the war may be higher than assumed in the forecast’s baseline scenario, one of the MPC members said. Businesses and households have fully adapted to operating under new conditions. The course of the war is no longer having as significant an impact as it used to have on their behavior and decisions. Under current conditions, this MPC member said, the NBU should take more proactive steps. Specifically, this MPC member is expecting significant capital inflows in the years ahead and is therefore seeing no threats to the sustainability of the FX market. An investment boom driven by both international injections and a return of the capital withdrawn from Ukraine (through round-tripping transactions, which are FDI with residents as ultimate controlling investors) will stimulate the economy without significantly ramping up inflationary pressure. Furthermore, under such a scenario, inflation is highly likely to be lower than the current forecast predicts. (However, several MPC members said that going forward, risks to the forecast of inflation and exchange rate sustainability remain high as active military operations grind on, missile attacks continue, export supply chain disruptions persist, etc.). 

Another participant in the discussion concurred, saying that despite the macroeconomic situation having improved more significantly than expected, the NBU continues to favor careful scenarios. 

Several MPC members said that surveys about future key-policy-rate decisions have revealed a big difference between what market participants expect from the NBU and what they consider an optimal policy. Specifically, a significant number of respondents continue to expect the NBU to be conservative. This indicates that the NBU’s monetary policy is predictable and that market participants understand why the central bank is pursuing it. However, increasingly more respondents consider it viable to reduce the key policy rate at a faster pace. This means the market is beginning to recognize that the regulator is moving slowly. Accordingly, not only will a more decisive reduction in the rate come as no surprise, but also it will reinforce confidence in the NBU’s policy. (However, several MPC members pointed out later on that the results of such polls should be treated with a high level of caution, as they lack transparency, samples are likely biased, and different groups of respondents have potential conflicts of interest). 

Nobody should expect an immediate reaction from financial markets and consumers to the reduction of the key policy rate, these MPC members said. Economic agents will have enough time to take advantage of the high yields on long-term hryvnia instruments. For its part, the NBU should look not only at the nominal size of the key policy rate, but also at the weighted average rate for all NBU instruments, the fixed exchange rate regime, the administrative restrictions, the reserve requirements, and more. Such a comprehensive approach produces deeper insights into the scope for easing the interest rate policy specifically. 

These MPC members also called for taking the high adaptability of public expectations into account when analyzing their impact on the real yields of hryvnia instruments. Households’ expectations can rapidly change in either direction under the influence of fast-moving ad-hoc factors, meaning that a worsening of expectations does not at all indicate a trend reversal all of the time. Specifically, the slight increase in households’ inflationary expectations in May–June may have been driven in particular by a purely emotional perception of the growth in power tariffs, the terrorist attack at the Kakhovka HPP, the spike in fuel prices, etc. This also applies to people’s exchange rate expectations. A certain weakening of the hryvnia in the cash market in recent days can be explained away, among other things, by news of the grain corridor’s termination, russia’s terrorist attacks on export logistics, and more active public clarifications by the NBU regarding the future currency liberalization. Expectations should therefore be adjusted for the impact of short-term factors that do not change the fundamental picture, which is generally conducive to a bolder reduction in the key policy rate. 

Three MPC members advocated a more moderate decrease in the key policy rate in July: two of them suggested cutting it to 23%, one to 22.5%  

These members agreed that the macroeconomic gains of recent months have indeed laid sufficient groundwork for an earlier start to the rate cut cycle. The NBU implemented the first stage of disinflation much faster than it expected to. At the same time, these MPC members warned against premature euphoria and a more aggressive easing of the interest rate policy. They said that under the current monetary regime, the key policy rate should be aimed primarily at maintaining exchange rate sustainability and that the current inflation rate is not a definitive benchmark for estimating the level of the key policy rate. 

They also pointed out that it may be rather difficult to slow inflation further and implement the Strategy. Specifically, they said, there is considerable uncertainty over the duration and intensity of the war, the risk of the grain corridor’s termination has materialized, and the possibility that individual EU countries may extend their trade restrictions on Ukraine’s agricultural products is still there. The winter is expected to be rough. In addition, the regularity of international support will primarily depend on the speed of reforms in Ukraine. The problem of a significant surplus of hryvnia liquidity is also still there. With uncertainty running high and new economic challenges emerging, previous gains can be lost very quickly, and the consequences of a policy reversal can be extremely dangerous.

If adverse risks materialize, the NBU will be forced to respond, said one of the participants in the discussion. Which means that it is important to prevent a situation whereby it would be necessary to correct errors caused by excessive optimism and to tighten the interest rate policy again, thus undermining confidence in it. The central bank should remain vigilant and avoid excessively sharp movements in order to minimize the likelihood of a negative scenario, this MPC member said.

Two other participants in the discussion agreed with this member’s perspective. A more cautious first step to reduce the key policy rate after a long period of no change, they said, would demonstrate policy consistency and stave off unnecessary shocks and more uncertainty. Such a step is better aligned with the Strategy, whose key provisions the NBU has been communicating over the past six months. The Strategy is intended to revive economic processes, meet the demand for the relaxation of restrictions, and add “oxygen” to the economy. If the macroeconomic situation improves and appropriate prerequisites emerge, the NBU should prioritize further steps to roll back the most burdensome FX restrictions and move to greater exchange rate flexibility as early as possible. At the same time, the implementation of the Strategy requires keeping hryvnia assets attractive enough to ensure exchange rate sustainability. If the key policy rate is chopped aggressively, especially with inflationary expectations being still high, real interest rates on hryvnia instruments may quickly retreat back into negative territory. Such developments would jeopardize the Strategy’s implementation and ratchet up risks to exchange rate sustainability during the transition to greater exchange rate flexibility.

In what has been a tremendous effort, the NBU has long operated a complex combination of monetary instruments, administrative levers, and verbal interventions to stimulate the growth in rates on hryvnia instruments and induce investors to take greater interest in them in order to alleviate pressure on the FX market, one discussion participant said. Achievements in this area are obvious and have ensured significant progress in setting the prerequisites for the further implementation of the Strategy. But more headway is needed. Accordingly, the reduction of the key policy rate and the revision of the forecast of its dynamics should be moderate in order to prevent a sharp drop in deposit rates. 

As a rule, banks respond to key policy rate changes asymmetrically: studies find that banks traditionally decrease their deposit rates faster than they raise them, this MPC member said. This asymmetry may currently intensify, in part due to the record surplus of liquidity, the high concentration of the retail deposit market, and the sharp drop in inflation. If the first key policy rate cut is too aggressive, it can provoke a disproportionately strong unintended response from the market, as can the announcement of a further accelerated reduction in the key policy rate. In contrast, moderate and gradual rate cuts by the NBU will amplify the positive effects of previous measures to enhance the attractiveness and maturity of hryvnia instruments. Among other things, this approach will better incentivize investors to maximize their return on the hryvnia by acquiring long-term instruments, making hryvnia deposits, and holding domestic government debt securities. This will in turn continue to alleviate the risks associated with the overhang of hryvnia liquidity and reduce the probability of resumption of monetary financing. The NBU will be able to reduce interest rates more decisively after the first stage of the transition to greater exchange rate flexibility is successfully completed, this MPC member said.

While flexibly adapting to changes in the current situation, the NBU should remain as consistent and predictable to financial markets as possible, another discussion participant said. A 2-pp cut to the key policy rate is the most anticipated decision, surveys have shown. Moreover, such a step would mesh well with the NBU’s previous announcements and would raise no doubts about the monetary policy’s consistency and compatibility with the Strategy. This is important for maintaining control over inflation and exchange rate expectations. By contrast, viewed through the prism of the NBU’s previous communications, a sharper first step and a faster subsequent rate reduction could be perceived as a reversal of the NBU’s strategy.  This may exacerbate uncertainty, trigger an excessive decrease in market rates, erode the demand for long-term hryvnia instruments, and put more pressure on the FX market. 

One of the discussion participants said that the emergence of a well-grounded and understandable program for Ukraine’s recovery, which the government stands to prepare at the European Commission’s request, will help dispel uncertainty. This will optimize the NBU’s policy by focusing it on bolstering the economy. In the meantime, it is necessary to keep up the work to create the prerequisites for ensuring that inflation steadily declines and financial stability is maintained. 

Although further interest rate cuts are expected by all MPC members, they significantly differ on the speed at which the interest rate policy should be loosened

Seven MPC members are expecting the rate to drop to 18%–19% by the end of 2023. Taking into account the anticipated pullback in inflation, this level of the key policy rate will make it possible to provide sufficient protection to hryvnia savings, these participants said. This will in turn continue to be an important condition for the sustainability of the FX market and the implementation of the approved Strategy. 

Two MPC members are seeing the prerequisites for a sharper reduction in the key policy rate. The disinflationary trend is stable, and the NBU’s capability to ensure exchange rate sustainability is high, especially considering the international aid disbursements expected in the coming years, these members said. As economic agents continue to adjust to the war, new challenges will no longer exert the same pressure on expectations as at the outbreak of the full-scale invasion, these MPC members said. This means there is room to take more decisive steps without jeopardizing macrofinancial stability.

At the same time, two other MPC members are expecting a slower easing of the interest rate policy, specifically that the key policy rate will go down to 20% by year’s end. It takes a more cautious approach to keep hryvnia assets attractive enough, especially given the significant number of risks associated primarily with the course of the war, these MPC members said. Were these risks to materialize, they could rattle expectations and thus macrofinancial stability in general. The NBU should continue to adhere to more balanced assumptions and avoid risky scenarios and policy reversals, these discussion participants said.