Dear colleagues,
I would like to greet all the participants at our traditional meeting following the Board's monetary policy meeting.
I would like to inform you that the Board of the National Bank of Ukraine has decided to cut the key policy rate to 19%. This was made possible due to a further alleviation of risks to price stability.
Headline inflation surprised on the downside. In March 2016, as expected, the disinflation trend continued, with annual headline inflation moderating to 20.9%. Core inflation continued to ease to 15.0% y-o-y. Overall, headline inflation rose by 1.6% q-o-q, underperforming the NBU’s inflation forecast.
Why has inflation been slowing in recent months?
Inflationary pressures have been dampened due to the authorities’ commitment to prudent monetary and fiscal policy, as well as subdued domestic demand. Inflation expectations of households, businesses, financial institutions and analysts are getting anchored. In particular, inflation expectations of households have fallen to a record low since November 2014.
It should be noted that the temporary surge in exchange rate volatility observed in January-February 2016 had a relatively limited impact on the inflation rate. This year prices for domestic and imported goods have been less responsive to exchange rate volatility than in 2014 or the first half of 2015.
There are several reasons to explain this phenomenon.
First, factors exerting pressure on the exchange rate due to lower foreign currency proceeds from exports also contributed to bringing domestic prices down. Thus, a plunge in global commodity prices drove prices for imported goods down, whereas new trade restrictions imposed by the Russian Federation have led to the redirection of exports to domestic markets, thereby exerting downward pressures on prices. As a result, raw food prices rose by only 0.2% q-o-q.
Second, the economy is gradually getting adjusted to a flexible exchange rate regime. As a result, businesses and households are becoming less responsive to exchange rate movements. All the countries that have exited from a fixed exchange rate regime to a floating one have followed this path.
Third, Ukraine’s economy has undergone a painful adjustment and redressed persistent external imbalances that have been building up for years. The current situation differs from what it formerly was.
To stay on this path, Ukraine should remain committed to a flexible exchange rate regime. It is important to bring to the minds of households, businesses and financial institutions that the exchange rate may either appreciate or depreciate, driven by fundamental factors and that the NBU always stands ready to step into the FX market to smooth excessive exchange rate fluctuations triggered by situational factors.
With this in mind, the NBU held 21 FX sales auctions between January and mid-March, through which USD 253 million was sold to banks. Since mid-March, the NBU has held 12 FX auctions and conducted an FX intervention at a fixed exchange rate. Overall, the NBU's net FX purchases in the interbank market amounted to USD 376 million. Today alone, the regulator has purchased USD 52 million that will be used to replenish Ukraine’s international reserves.
The NBU has kept its headline inflation projection unchanged at 12% by the end of 2016 and 8% by the end of 2017, which is consistent with its inflation objectives.
How would the inflation objective be met?
Most factors causing inflation to deviate from the projected path in the first quarter are believed to be short-lived, with a high likelihood of their reversal over the next quarters. At the same time, the disinflation trend will be supported by a number of factors.
First, subdued domestic demand. The NBU expects real GDP to rise by 1.1% in 2016 and by 3.0% in 2017.
The economic recovery will be supported by a rebound in demand and prices for Ukrainian export commodities. Lower inflation and abating depreciation pressure will stimulate businesses to implement deferred investment projects and encourage households to make deferred purchases.
At the same time, if Ukraine remains on track with its IMF-supported program, it is highly likely that the NBU will revise its GDP forecast upwards in July.
Second, low global food prices will keep inflation on a downward trend. Despite a gradual recovery in global food prices, these prices will remain lower than a year ago.
Third, the exchange rate depreciation, which was observed in March-April. will feed through into consumer prices over the next months.
Regarding other factors that might have an impact on prices through the exchange rate in the period ahead, these factors will be relatively balanced. Following a sharp fall in the first quarter of 2016, exports are expected to rebound in the second quarter of 2016, driven by a recovery in global prices for ferrous metals and iron ore. These developments have led the NBU to keep its forecast for the current account deficit unchanged. The current account deficit is expected to stand at USD 2.3 billion or 2.7% of GDP in 2016 and USD 1.8 billion or 1.9% of GDP in 2017.
And finally, the disinflation trend will be underpinned by prudent fiscal policy. Despite lower revenues to the social funds due to a cut in the basic rate of the unified social tax, the general government deficit is expected to narrow. The decline in the general government deficit will be underpinned by restrictions on budget spending, a narrowing of the Naftogaz NJSC deficit, and lower quasi-fiscal expenditures, which will totally eliminate the possibility of fiscal dominance over monetary policy.
The upside risks to price stability, which prevented the NBU from easing monetary policy in the first quarter of 2016, have significantly abated since the NBU Board's previous meeting on monetary policy.
In particular, political tensions have eased with the formation of a new government. External risks have subsided due to the resumption of transit of Ukrainian goods through the territory of the Russian Federation and a gradual recovery in prices for key Ukrainian export commodities.
However, delays with the resumption of cooperation with the International Monetary Fund remain the major downside risk to inflation projections. In particular, the lack of progress in the completion of the second review under the Extended Fund Facility Arrangement has prevented the build-up of international reserves at a pace consistent with our estimates. Today, the NBU Board has had to revise its end-year international reserves forecast downward from USD 19.6 billion to USD 18.7 billion. Furthermore, Ukraine’s success in remaining on track with its IMF-supported program is critical to economic growth. Accordingly, the new Government's commitment to proceed with urgent reforms is essential to getting the program back on track.
In view of the current economic situation, the updated macroeconomic forecast, and the downside risks to this forecast, the NBU Board has decided to resume monetary easing.
Should risks to price stability abate further, the NBU may move ahead with the monetary easing following the resumption of cooperation with the IMF.
At the same time, the NBU has streamlined the operational framework of monetary policy.
This move has been prompted by the need to enhance the effectiveness of monetary instruments to strengthen the NBU’s ability to implement monetary policy in the context of inflation targeting, as envisaged by the Monetary Policy Strategy approved by the NBU Board in August 2015.
What is the operational framework of monetary policy?
The operational framework of monetary policy refers to a set of monetary policy instruments used by the NBU, as well as interrelations between these instruments.
The key policy interest rate is a central element of the operational framework of monetary policy. Presently, the banking system has a structural liquidity surplus. Banks have invested about UAH 60 billion in certificates of deposit (CD). Over UAH 40 billion is held in correspondent accounts, which brings the total liquidity figure to over UAH 100 billion.
This figure exceeds outstanding debt on refinancing loans (by principal amount) owed by solvent banks. The outstanding debt amounts to UAH 40.5 billion. Since the beginning of this year alone, banks have paid back UAH 12.1 billion to the NBU and continue servicing their debt obligations.
Under such circumstances, the 14-day CD interest rate serves as the key policy rate. Presently, the 14-day deposit-taking operations, which account for the largest share of all the CDs placed with banks, have a key impact on money market conditions.
Up until now, the discount rate was different from the 14-day CD interest rate. The discount rate was set at 22% (effective from September 2015), while the rate on the 14-day CD interest rate was set at 20%. From now on, the NBU will identify a single policy rate, setting it at 19%. Thus, the key policy rate will be the same as the 14-day CD interest rate.
It should be noted that if the liquidity surplus turns to deficit, the NBU will change the key monetary policy instrument. Therefore, the key policy rate will anchor the rates on refinancing facilities.
Why is it necessary to unify the key policy rate with the 14-day CD interest rate?
Actually, we turned the de jure key monetary policy interest rate into the de facto key policy rate.
This policy rate will reflect the central bank's desired level of short-term interbank interest rates. At the same time, we will put in place mechanisms to push short-term market rates to levels close to the key policy rate.
This move is intended to improve the first link of the chain of cause-and-effect of the transmission mechanism of monetary policy. In other words, it will boost the central bank’s ability to steer interbank interest rates.
Going forward, changes in the key policy rate as the key reference interest rate and policy-induced changes in interest rates will be translated into changes in interest rates on other financial assets (in particular, government securities) and retail interest rates on loans and deposits. Changes in these rates will feed through into consumption and investments of households, and, accordingly, inflation.
Therefore, the clarity and predictability of key policy rate adjustments will contribute to increasing the effectiveness of the transmission mechanism of monetary policy through which the NBU steers inflation towards the inflation objectives.
As part of the monetary policy operational framework, the NBU has narrowed the corridor of interest rates on standing facilities around the discount rate.
The interest-rate corridor is symmetric around the discount rate (+/-2 percentage points on either side of the key policy rate). The top of the interest rate corridor is the interest rate on standing overnight refinance facilities. The bottom of the interest rate corridor is the interest rates on an overnight deposit facility. The daily unrestricted access to these facilities is essential to the effectiveness of the central bank's interest-rate policy. This mechanism will enable the NBU to limit interbank interest rate volatility within the interest rate corridor set by the standing facilities.
Additionally, the NBU has also streamlined the liquidity management instruments that play a complementary role in the NBU’s interest rate policy.
The NBU will hold CD placement tenders at maturities of 14 days. The NBU will cease conducting deposit-taking operations at maturities of less than one week and one month.
At the same time, the NBU has disallowed the early repayment of NBU CDs as this is no longer needed.
The main advantages of the new operational framework of monetary policy can be summarized as follows: The new operational framework enhances the clarity and unambiguity of monetary policy communication. When the NBU changes its policy rate, all market participants will have a clear understanding of how the market will react based on how other central banks’ interest rate moves affected their markets.
Anticipating your questions, I would like to explain why we have decided to redesign the operational framework now.
The following two prerequisites put in place in 2016 enabled the NBU to reshape its monetary policy.
First, the NBU no longer needs to finance fiscal and quasi-fiscal needs.
Second, there is weaker demand for refinancing loans from banks and surplus liquidity in the banking system is expected to persist through 2016.
At the same time, the NBU Board believes that the current economic situation and the balance of risks enable the regulator not only to ease monetary policy, but also to relax administrative restrictions on FX market operations in a gradual manner.
The NBU intends to lift the ban on the repatriation of dividends from Ukraine.
Every client may choose one bank through which the purchase of foreign currency and payment of dividends will occur.
The regulator will oblige banks to ask their customers whether or not they intend to pay dividends in foreign currency and submit this information to the NBU. Following the receipt of information on intended dividend payments, the NBU will set a schedule for dividend payments. The ban will be lifted following the successful completion of the second review under the Extended Fund Facility Arrangement with the IMF.
The NBU will move ahead with its plans to phase out administrative restrictions on FX market operations once cooperation with the IMF resumes.
I would like to draw your attention to the fact that our updated projections will be available in the Inflation Report to be published on 25 April 2016.
Our next meeting on monetary policy issues will be held on 26 May 2016, as scheduled.
Thank you for your attention!