Dear colleagues,
Please be informed that the Board of the National Bank of Ukraine has decided to cut the key policy rate from 8% to 6% per annum. This is the lowest level of the key policy rate since Ukraine gained its independence.
The NBU decided to continue to ease its monetary policy at a fast pace, considering that consumer and investment demand are most likely to remain subdued for longer than forecast in April.
On the one hand, this will keep inflation below the target level of 5% +/- 1 pp for longer than projected in the April forecast. On the other hand, this means that the Ukrainian economy will face a deeper contraction than expected.
This requires the central bank to continue its monetary policy easing in order to support the economy as the country gradually lifts quarantine measures.
What inflation developments followed the last monetary policy meeting held in April?
In April–May, inflation hovered around 2%, being lower than expected and significantly below the target range of 5% ± 1 pp.
Inflationary pressures remained weak primarily due to a noticeable drop in consumer demand for food and nonessential goods.
Moreover, inflation was restrained by several factors, which included lower energy prices, increased supply of vegetables, and frozen prices for many services during the quarantine.
These factors offset the effects of the hryvnia’s weakening in March and the sustained high demand for some goods in early April – these effects having completely vanished as of now.
How will inflation behave throughout the rest of the year?
Having been low for several months, inflation will grow moderately. However, it is likely to head towards the target range more slowly than expected.
First, consumer and investment demand remain subdued, although business activity has started to pick up gradually as the quarantine restrictions are eased.
In particular, a deep fall in retail trade (by 15% yoy) was recorded in April, for the first time since 2015. That is a clear indication of a large decline in consumer demand.
According to the NBU’s estimates, the fiscal and monetary policy measures taken with the aim of supporting businesses and households will only partially offset the decline in consumer demand. The recovery of consumer demand will be gradual even after the quarantine is lifted.
Second, the FX market, which has a major impact on the price of the basket of goods, is favorable for low inflation. Since the start of April, the supply of foreign currency on the interbank market has exceeded demand. Imports of goods remain below pre-crisis levels across almost all categories of goods, while exports are declining more slowly.
As a result, the hryvnia strengthened and since early April the NBU has used this opportunity to purchase around USD 1.8 billion in order to increase international reserves. In such a way, the NBU has become a net buyer of foreign currency since the start of the year, having compensated for the outflow of foreign currency from international reserves in March due to high demand for foreign currency.
Third, inflation expectations are improving among households and financial analysts. According to the NBU, their current expectations of inflation in 12 months have aligned with the NBU’s medium-term target.
What were the other considerations behind today’s decision?
The NBU’s key assumption of continuing cooperation with the International Monetary Fund realized this week.
On 9 June, the IMF Executive Board approved a new cooperation program with Ukraine – an 18-month Stand-By Arrangement amounting to USD 5 billion. The first tranche of USD 2.1 billion will be received today. This has provided Ukraine with access to financing from the World Bank and the EU, which has already disbursed EUR 500 million to the Ukrainian government. This year, the total amount of official financing is expected to reach over USD 5 billion, with more than half of that amount received from the IMF.
These funds would fully finance budget expenditures on counteracting the negative effects from the coronavirus pandemic and quarantine restrictions.
In addition, they would increase international reserves. After Ukraine receives the first IMF tranche international reserves will increase USD 27 billion. Despite there being significant repayments of external public debt, international reserves will exceed USD 27 billion – a figure higher than that seen before the crisis.
A program with the IMF would also facilitate Ukraine's access to the international capital markets.
A longer-lasting coronavirus pandemic and the quarantine measures required to overcome it, both in Ukraine and globally, remain the key risk to macrofinancial stability. In addition, it is critically important to continue structural reforms and to maintain a prudent macroeconomic policy.
Given the expectation that inflation would be below its target for a longer period of time, the NBU Board cut the key policy rate by 2 pp, to 6%. Overall, the key policy rate has decreased by 7.5 pp since the start of the current year, hitting a historic low in independent Ukraine.
Monetary easing and other anti-crisis measures taken by the NBU in recent months will support business activity in the country. Although the contraction has already bottomed out, the NBU estimates that the extent of the contraction in Q2 will be greater than expected. Therefore, measures to put the economy back on the track to growth need to be rather decisive.
The NBU has also decided to narrow its interest rate band on standing facilities, from the key policy rate +/- 2 pp to the key policy rate +/- 1 pp. This means that with the new key policy rate, overnight refinancing loans will be issued at 7%, and overnight certificates of deposit will be placed at 5%.
By changing the width of the band, the NBU will be able to achieve the operational goal of its monetary policy, which is to keep hryvnia interbank rates close to the key policy rate, and within the band of interest rates on standing facilities.
What will be the NBU’s monetary policy stance in future?
A decrease in the key policy rate below its neutral level indicates the end of the cycle of rapid monetary policy easing. The potential for cutting the key policy rate at a high pace of 2 to 2.5 pp each meeting, which the NBU has been doing since autumn 2019, has effectively been exhausted.
Given the high level of uncertainty, the NBU’s future monetary policy will mainly depend on:
- how great is the fall in consumer demand, which weakens inflationary pressures
- on the other hand, it will be driven by the speed of the recovery of business activity on the back of relaxed quarantine measures, which will accelerate price growth.
Thank you for your attention!