Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 8 December 2021

Date of the meeting: 8 December 2021.
Attendees: all ten members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Kyrylo Shevchenko, NBU Governor
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director of the Financial Stability Department
• Volodymyr Lepushynskyi, Director of the Monetary Policy and Economic Analysis Department
• Oleksii Lupin, Director of the Open Market Operations Department
• Yuriy Polovniov, Director of the Statistics and Reporting Department. 

During the meeting, the MPC members focused on the analysis of factors that may delay the reduction in inflation, and the actions the NBU needs to take to neutralize them and ensure a steady slowdown in inflation to 5%.

Inflation peaked in September and began to decline in October–November, but at a slower pace than expected, the MPC members pointed out. This was due to the growing impact of the global spike in prices for a wide range of goods and services in the domestic market due to second-round effects. Inflation also continues to be fueled by rising business spending on logistics and wages.

Higher-than-forecast wage dynamics are driven by systemic factors, including sustained demand for labor in Ukraine and abroad. On the other hand, the current slowdown in nominal wage growth on an annualized basis is largely due to the high base effect.

Underlying inflationary pressures remain stable. That includes core inflation, which has been rising slowly. Domestic consumer demand remains robust despite a slight deterioration in consumer confidence and stricter quarantine restrictions. At the same time, businesses in both industry and the service sector are still struggling to ramp up production capacity to meet demand, according to surveys by the State Statistics Service of Ukraine and the NBU.

Inflation expectations of all groups of respondents are slowly deteriorating. The share of households expecting above-10% inflation over the next 12 months has surpassed 60%. Companies across all economic sectors continue to anticipate an accelerated rise in their selling prices amid higher costs of raw materials and supplier prices. Prolonged high inflation and the threat of escalated military aggression by Russia have increased the risk of a further unbalancing of expectations.

Rising geopolitical tensions are also adversely affecting FX market conditions and prices for Ukrainian assets. FX demand from businesses and households has risen. Global demand for risky assets is also at risk of weakening further as leading central banks tighten their monetary policy stances in response to accelerating global inflation.

The discussants agreed that with the balance of inflation risks having shifted, the NBU should strengthen its monetary policy to prevent an anchoring of inflation and expectations to high levels. Alternatively, keeping the key policy rate unchanged would result in inflation expectations worsening further, capital leaving Ukraine, and yields on domestic government debt securities growing. As a result, the NBU would still have to fight elevated risks, but through a more radical tightening of monetary policy, which would cause additional losses for the economy.

Seven members of the MPC called for raising the key policy rate to 9% in December.

Given the current inflation dynamics, its forecast, and a marked increase in inflation risks, raising the rate is the only option, one discussant emphasized. Global energy prices will remain high for a long time, and this will affect the prices of a broad range of goods and services, this MPC member said. That includes fertilizers, which have significantly risen in price due to expensive energy and will affect food prices. Meanwhile, rising food prices are rapidly translating into worsening inflation expectations of households, which spend a significant portion of their income on food. It is also possible that the next harvest will fall short of this year’s record levels, potentially having an adverse impact in H2 2022.

This MPC member thus pointed out that they had considered raising the key policy rate by 1 pp, but had eventually decided on a 0.5 pp increase. During 2021, the forecast of real GDP growth in Ukraine was revised downwards by the NBU, while the inflation forecast was adjusted upwards, this MPC member said. This indicates that the economic recovery from the crisis has been weak. In making its decisions, the NBU must therefore take into account that too aggressive a tightening of monetary policy may trigger recessionary processes in the economy.

Another MPC member said that they, too, had found themselves choosing between a 0.5 pp increase and a 1 pp hike, but in the end had also opted for 0.5 pp. This was in part due to the fading of some of the global pro-inflationary factors and because of projections of a gradual slowdown in global inflation. For instance, freight prices are falling, a sign that the impact of global supply chain disruptions is weakening.

Although consumer demand in Ukraine remains sustained, it has stopped growing in recent months, this discussant also indicated. Annual growth rates of nominal and real wages, as well as those of retail sales turnover, are declining. On a quarter-on-quarter basis, consumer demand does not appear to be overheating either. Given these factors and the slower pace with which the Ukrainian economy is making its way out of the crisis, the NBU should only take moderate action. This is necessary in order to maintain the confidence of market participants, on the one hand, and not to harm economic recovery, on the other. Furthermore, with bank loans currently being relatively small as a share of financing of consumer spending, stimulus from consumer lending remains rather limited.

The NBU has reiterated its commitment to return inflation to its target, becoming one of the first central banks to take a tighter monetary policy approach this year, this MPC member also emphasized. Raising the key policy rate by 0.5 pp while reaffirming the commitment to strengthen the monetary policy further is an adequate response at this point.

Another discussant also considered a more significant increase in the key policy rate, but also chose the 0.5 pp option. Key arguments in favor of this decision were the signs of a gradual slowdown in inflation and an easing of underlying inflationary pressures. This is seen, in particular, from the invariability of the average shopping receipt at retail chains in recent months amid rising prices.

In the conditions of weak monetary transmission through the interest rate channel, as well as significant depreciation pressure, the NBU’s current key policy rate decisions should primarily aim to improve inflation expectations, several MPC members said. A 0.5 pp increase meets market expectations, while a larger increase may be perceived as an emergency hike amid a military escalation and a tightened quarantine. At the same time, the moderate increase in the key policy rate should be accompanied by additional measures to strengthen monetary transmission, including efforts to mobilize excess liquidity in the banking system, these MPC members said.

Three members of the MPC called for raising the key policy rate to 9.5% in December.

These participants agreed that delays in tightening the monetary policy stance posed a threat to returning inflation to its target range in 2022. Previous inflationary developments have already warranted a sharp hike, and the current environment makes this action even more urgent, these discussants suggested. As a result, some of the factors that the NBU previously deemed elements of uncertainty have turned into pro-inflationary risks since the last MPC meeting. Some of these risks have already materialized, while others have intensified. Most drivers of inflation that used to be seen as transitive have evolved into long-term ones and are becoming systemic. This is increasingly recognized by central banks. The NBU’s inflation forecasts are constantly being revised upwards, and the inflation trend is again above the October forecast, indicating that inflationary pressures have been underrated. Judging by the dynamics of expectations about inflation and the key policy rate, it appears that economic agents are increasingly less confident in the NBU’s proactive actions and ability to return inflation to 5% in 2022. The NBU’s wait-and-see approach to monetary policy is not making economic agents more confident. To maintain its credibility, the central bank must show greater resolve in its pursuit of lower inflation.

A further intensification and materialization of inflation risks is a more likely scenario than a rapid disinflation, these MPC members said. The trajectory of the key policy rate forecast published in the October Inflation Report, which envisages maintaining the rate at 8.5% until at least Q3 2022, is therefore currently too low to bring inflation back to 5% next year. Market participants also understand this, and they will not perceive a 1 pp hike as extraordinary.

More decisive actions by the NBU will have a positive impact on inflation, first through the expectations channel, which now plays a key role, and then through the interest rate channel, one of the discussants said. A tighter policy response than anticipated by the market could thus eventually result in banks making more significant changes to their interest rates. Given the current balance of inflation risks, the key policy rate should be raised to its neutral level, this MPC member said.

The exchange rate channel, which has up until now been the most effective of all channels, has lost its disinflationary power, one of these MPC members said. As a matter of fact, the hryvnia has weakened and is under pressure. Risks of a large-scale military offensive by Russia and the spread of the Omicron variant are actively discussed in the media and are negatively affecting the expectations of FX market participants and other economic agents. The hryvnia has come under additional pressure from the gradual tightening of monetary policy throughout the world. This dampens investor appetite for risky assets and thus may reduce the portfolio of Ukrainian government bonds held by investors. Moreover, the significant liquidity surplus in the banking system diminishes the performance of the interest rate channel of monetary transmission. To address this problem, the NBU must take decisive and sweeping measures that will not be limited to key policy rate moves.

The rise in global energy and grain prices will continue to affect consumer prices for a long time, this discussant said. Agricultural businesses, processing plants in particular, expect further increases in purchasing prices and are forced to revise prices for their products as feed and fertilizers grow more expensive. Retail chains are currently operating with low profitability. As a result, most of the pressure from purchasing prices will feed into retail prices. Under such conditions, even a rather large key policy rate hike will in 2022 reduce inflation only to the upper limit of its target range, and a return to 5% will occur closer to mid-2023, this MPC member said.

In discussing the forecast trajectory of the key policy rate, all MPC members agreed that bringing inflation to 5% in 2022 would likely require a further tightening of monetary policy.

Most MPC members called for further increases in the key policy rate at the NBU Board’s next meetings on monetary policy issues. Several discussants also highlighted the need to speed up the implementation of additional measures aimed at strengthening the transmission of previous key policy rate hikes, in particular by regulating liquidity in the banking system.  

The decision to raise the key policy rate to 9% per annum was approved by the NBU Board at the monetary policy meeting held on 9 December 2021.