Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 7 December 2022

Date of the meeting: 7 December 2022.
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 changes in the balance of risks to inflation dynamics and economic development

In November, inflation developments were slightly better than the trajectory in the NBU’s baseline forecast (October 2022 Inflation Report), the MPC members said. First, the increase in the supply of raw food products as the new crop harvest came in helped. This factor’s impact was amplified by export disruptions and a limited capability to process certain types of products. Second, the liberation of part of the Kherson oblast helped expand the supply of goods to this region, also restraining the acceleration of inflation. Third, russia’s energy terror and a reduction in household income weakened consumer demand. Sell-offs of perishable goods due to power outages also had an ad-hoc disinflationary effect.

Inflation was also restrained by the measures the NBU had taken previously to maintain exchange rate stability and make hryvnia assets more attractive. Specifically, fixing the hryvnia official exchange rate, maintaining the key policy rate at 25%, limiting, as planned, the monetary financing of the state budget, expanding the range of tools to ease FX risks, as well as calibrating FX limits together with increasing the volumes and establishing the regularity of international financing, contributed to the partial stabilization of expectations and helped ease FX market pressure. This was evidenced, among other things, by the narrowing of the spread between the hryvnia’s official and cash exchange rates and the reduction of net FX sales by the NBU.

In recent months, some pro-inflation risks have also moderated. In particular, despite russia’s attempts at blackmail, the grain corridor has continued to operate. Other supply chain disruptions have also been gradually easing. This has been driving Ukrainian exports, FX earnings, and budget revenues.

In addition, the risk of receiving less than enough external financing in 2022–2023 has eased as international partners confirm previous arrangements and negotiations with the IMF make progress. The timely arrival of the announced volume of international aid, coupled with the revival of domestic borrowing, will help cover the budget deficit in 2023 without resorting to monetary financing and maintain sufficiently high international reserves, the NBU estimates. 

As the full-scale war grinds on, however, price pressures are still significant, and the balance of inflationary risks remains shifted upwards. Risks associated with the war’s escalation, duration, and scale remain the key factors that will shape inflation dynamics going forward. Although inflation expectations for the next 12 months are showing early signs of moderating, they are staying close to their peak levels seen during past crisis episodes. What is more, russia’s energy terror tactics are exacerbating the unanchoring of longer-term expectations. With there being a significant surplus of hryvnia liquidity and a limited supply of attractive instruments in which to invest the hryvnia, heightened inflation expectations are increasing the sensitivity of the financial system, in particular the FX market, to spontaneous factors.

In addition, the recovery of exports has decelerated. Maritime corridors are letting through only agricultural products, but even these deliveries are being slowed as russia deliberately delays ship inspections. An additional factor suppressing pro-inflation risks has been the drop in world prices for Ukraine’s exports (food and metals-and-mining products) amid a global recession and expectations for good harvests around the globe.

The energy terror perpetrated by russia has pushed businesses’ production costs further up, in part due to increased energy prices and the need to purchase generators to maintain uninterrupted operations. At the same time, production volumes have declined because of the blackouts. In what is now regular practice, russia has been launching massive air strikes against Ukraine’s energy facilities, and power grid repair times have grown. Worse yet, the shortage of electricity is driving a stronger demand for fuel, making it more expensive. As a result, the destruction of energy infrastructure can affect the prices of a wide range of goods and services.

Inflationary pressures will be only partially offset by the waning of consumer demand due to reduced incomes, significant additional expenses to meet household needs amid power outages, saving on nonstaple purchases, and forced migration.

The MPC members discussed several scenarios of further economic development, with energy terror varying in scale from one scenario to another. The current baseline scenario assumes that Ukraine’s air defense systems will continue to operate with a fair rate of success, that damaged energy facilities will undergo  relatively quick repairs, and that the shortage of power will not exceed 25% of the total need.

Even this scenario, however, will have an adverse impact on inflation dynamics and weigh down on economic recovery in 2023. Should the scenarios with more serious damage to critical infrastructure and longer power outages materialize, the macroeconomic forecast for the next year will have to be revised more significantly, meaning a continued fall in GDP.

Considering the balance of risks, the MPC members, for the fourth time running, unanimously spoke in favor of keeping the key policy rate at 25%

Keeping the key policy rate at 25% over the past six months, along with the pursuit of a fixed exchange rate regime and measures to regulate the FX market, has played an important role in maintaining macrofinancial stability as the full-scale war wears on, all discussants agreed. Through this policy, the NBU has managed to keep exchange-rate and price pressures in check and make certain progress in stabilizing businesses’ and households’ expectations.

The NBU has, by consistently communicating its steps and fulfilling its commitment to pursue a relatively tight long-term monetary policy, facilitated a gradual increase in bank rates on hryvnia deposits, the MPC members said. This reversed the trend towards the shrinking of the share of retail term deposits. The effects of the June key policy rate hike have not yet faded. There is still ample room for further transmission to market interest rates. Therefore, the decision to maintain the key policy rate at the current level will help to both solidify the gains noted above and propel the further growth in the investment appeal of hryvnia assets. It will also aid in reducing uncertainty and thus preserving exchange rate stability and the gradual decline of inflation in the years ahead, the MPC members said.

The decision to keep the key policy rate unchanged appears the most balanced one, several discussants pointed out. The easing of some pro-inflation risks since the previous meeting of the MPC has been offset by new sources of inflationary pressure. No change in the key policy rate in December is a decision that financial market participants anticipate, according to market surveys. It will therefore contribute to fortifying confidence in monetary policy.

To the contrary, an unexpected move to cut the key policy rate, even by a relatively small increment, could trigger a deterioration of expectations in the current environment and add to uncertainty. On the other hand, a rise in the key policy rate would currently be difficult to justify, as it may lead to an excessive tightening the NBU’s monetary policy stance.

Most MPC members expressed the need to keep the key policy rate at the level of 25%, at least throughout the next year. Meanwhile, several MPC members highlighted the emergence of prerequisites for a slightly faster transition to a cycle of key policy rate cuts

The October forecast, which predicts that the key policy rate will stay at the 25% level until Q2 2024, is highly likely to materialize, most discussants said. High inflationary risks persist, and the objectives of the June hike to 25% are still relevant, they said. A decision to cut the rate in the short term would therefore appear unreasonable and inconsistent. The NBU can only send signals about a potential easing of monetary policy if a corresponding improvement in macroeconomic conditions occurs, one of these MPC members said. Otherwise, such signals may damage the central bank’s authority, independence, and institutional resilience.

Businesses’ and households’ expectations are rather shaky, and FX market conditions remain tense, as the war has significantly limited Ukraine’s exports, one of these MPC members said. Meanwhile, the need for imports, especially energy imports, is only growing, and the reliance on external sources of financing is very significant. Given the elevated geopolitical risks and the threat of a global financial crisis, further interest rate increases around the world are quite possible, as is another rise in the NBU’s key policy rate, this MPC member said.

Conversely, some MPC members believed that the NBU could start a monetary policy easing cycle earlier than envisaged in the October forecast. They expected that the key policy rate would be cut by 2 to 4 pp next year. Two of them said that they saw the grounds for easing monetary conditions in H1 2023.

According to one participant, the NBU was not currently operating in the classical inflation targeting regime, which requires a central bank to respond to all inflation shocks. Thus, the risk that inflation will rise over the next months has increased because of effects arising from damage to energy infrastructure. However, this is largely due to supply-side shocks, the impact of which will gradually fade away in H2 2023 even without any active monetary actions. The NBU’s monetary measures are currently aimed for the most part at safeguarding exchange rate stability. The NBU has achieved certain progress in that regard. More specifically, even with the current effectiveness of monetary transmission, the NBU’s measures, together with external factors (such as the receipt of international aid) created monetary conditions that helped stabilize the FX market and pushed up international reserves beyond their pre-war levels. The arrival of large amounts of promised international aid in early 2023 would further decrease uncertainty and risks to the economy, while noticeably boosting the NBU’s ability to deliver exchange rate stability and to keep expectations in check. This will provide the NBU with room to launch a monetary policy easing cycle more quickly.

Most MPC members agreed that pro-inflationary risks would continue to prevail in the coming months, and that, if realized, these risks would require the central bank to tighten monetary conditions in order to keep the exchange rate and inflation under control. Therefore, the NBU should continue to stick to its one-way communications in announcing possible monetary policy changes in the baseline scenario. At the same time, several MPC members noted that the balance of risks was levelling off, and suggested that the NBU adopt symmetrical communications in declaring its future monetary policy stance.

The participants focused on analyzing factors that dampen the effectiveness of the interest rate channel of monetary transmission, and on measures that make this channel more effective. As a result, they unanimously supported the decision to tighten reserve requirements (RRs)

The MPC members agreed that the key factors holding back the response of market rates to the June key policy rate hike were the surfeit of liquidity in the banking system, depressed competition on the deposit market, and the lack of attractive instruments for hryvnia savings.

More specifically, the extremely high level of liquidity is currently concentrated in several of the largest market maker banks. This is mostly due to the fact that large amounts of social and other payments to households and payments to the military are unevenly redistributed in the banking system. A reduction in lending, in particular consumer lending, also played a role by decreasing the intensity of liquidity redistribution.

Real interest rates on hryvnia deposits remain in negative terrain, with depositors, due to flight-to-liquidity and flight-to-quality, mostly keeping their money in current accounts with a view to buying FX or durable goods. Given heightened inflation and exchange rate expectations, the lack of attractive instruments for hryvnia savings is generating risks to macrofinancial stability. This requires additional measures to reduce these threats and to safeguard financial stability.

Most MPC members called for increasing the RR ratios for hryvnia and FX current accounts by 5 pp and allowing the banks to use benchmark domestic government debt securities to meet up to 50% of their total required reserve ratios. This is one of the measures under the action plan developed during the consultations the NBU and the Ministry of Finance had with the IMF. The action plan also envisages that the government would adjust yields on domestic government debt securities factoring in the market conditions in order to finance the budget without issuing new money in 2023 and support the NBU’s measures to enhance monetary transmission. Several participants pointed out that it was reasonable to implement relevant arrangements and agree on the list of benchmark domestic government debt securities to be included in the coverage of reserve requirements after yields on respective securities approach market levels at primary auctions.

MPC members agreed that the implementation of the said measures will help accomplish several important tasks. First, this will allow absorbing a portion of excessive liquidity and encourage banks to compete more for term deposits by changing their prices. Therefore, interest rates on long-term deposits will grow further, longer-term hryvnia savings will become more attractive for depositors, the dollarization of the economy will slow, and pressures on the FX market will ease. As a result, risks to macrofinancial stability will subside. Second, such measures will create stimuli for banks to increase their portfolios of hryvnia domestic government debt securities. The revival of the domestic borrowing market, improved transparency of price setting, and narrower spreads will contribute to attaining a 100% rollover of hryvnia domestic government debt securities. This will lower the risk of returning to the monetary financing of the budget deficit next year.

The discussion participants also did not rule out further increases in the RR ratio for hryvnia and FX current accounts

Several MPC members emphasized that is was reasonable to hike the RR ratio for current accounts by as much as 10 pp in December. As one of them noted, in its decisions the NBU must take account of not only the current liquidity of the banking system, but also its prospective state. The banking system’s liquidity surplus will continue to widen, in the view of the structure of budget deficit financing sources, continued expansionary fiscal policy, and large expenditures on payments to service people and social needs. Therefore, the MPC member believed it would be better for the NBU to take the resolute step already then instead of protracting the increase in RR ratios.

At the same time, all discussion participants agreed that, taking into account the arrangements made during negotiations with the IMF, it would be sufficient to raise the RR ratios by 5 pp in December. A decision regarding another hike of RR ratios should be made in January 2023 depending on how the situation unfolds.

MPC members also supported other efforts to enhance monetary transmission. They noted that, by hiking its key policy rate, the NBU had created market stimuli for the banks to raise their rates on retail and corporate term deposits in the hryvnia. However, due to some factors, including the inert interest rate policies of the banking sector’s largest market makers, such market stimuli did not result in sufficient supply of deposit products with attractive rates. Therefore, the NBU should develop additional effective measures to boost competition for depositors, prompting the banks to raise their deposit rates more actively, which is needed to maintain the macrofinancial stability amid the war.

During the discussion, MPC members also agreed that in January they would discuss potential changes in the operational design of monetary policy after the macroeconomic forecast is updated, while also taking into account the dynamics of prices and inflation expectations, results of implemented measures, and their impact on the FX market and the domestic debt market.

All discussion participants agreed that the NBU should continue to pursue a relatively tight monetary policy for a long time in order to maintain macrofinancial stability.