The Board of the National Bank of Ukraine has decided to hike its key policy rate to 16% per annum, effective from 26 January 2018. The tighter monetary policy will help decrease the inflation and bring it back to the target range in the middle of 2019.
In 2017, headline inflation reached 13.7%, exceeding the target of 8% ± 2 pp set for the National Bank of Ukraine in the Monetary Policy Guidelines for 2017 and Medium Term.
Inflation sped from 12.4% in 2016, mainly due to factors on which monetary policy tools have only a limited effect. In particular, acceleration of inflation was mainly driven by a decrease in the supply of some foods resulting from the unfavorable weather conditions seen in the first half of last year, the unstable situation in animal breeding, and a rise in the global prices of, and demand for, Ukrainian foods, mainly meat and dairy products.
An increase in production costs, especially labor costs, and fast recovery of consumer demand also contributed to the growth of prices.
In addition, the end of last year saw an increase in hryvnia exchange rate fluctuations and a noticeable easing in fiscal policy, thanks to, among other things, sharp increase in pension payments and budgetary spending being unevenly distributed over the year. This increased underlying inflationary pressure, as evidenced by a rise in core inflation, to 9.5% in December, and high inflation expectations. As a consequence, the deviation of inflation rate from the target was larger than the NBU anticipated in its October 2017 Inflation Report.
Headline inflation is expected to slow down and return to the target in the middle of 2019
Inflation will gradually decrease in 2018 through 2020, mainly due to the central bank conducting a tight monetary policy over forecast horizon. However, the NBU projects that inflation will remain high in 2018: headline inflation will be 8.9% and core inflation will be 8.2%. This inflationary pressure will be due to several factors, such as:
- the rise in the prices of raw foods (mainly meat and milk) that occurred last year passing through to the prices of highly processed foods;
- a pick-up in consumer demand, driven by household income growth resulting from both higher social standards and a further increase in wages in the private sector amid high demand for labor;
- an increase in the external vulnerability of the Ukrainian economy, due to delayed cooperation with the IMF, which makes it more difficult for Ukraine to attract capital, and consequently, puts pressure on the hryvnia exchange rate;
- the high inflation expectations of households and businesses, resulting from consumer prices’ current pace of growth, and the FX market volatility seen in recent months;
- a hike in global oil prices, which pushes domestic prices up.
In the future, the inflation decrease will be ensured by a tight monetary policy, a rise in supply of foods and a slow down of imported inflation. Respectively, the growth rates of both raw food prices and core inflation heavily dependent on the former will decline. As a result, the inflation will return to its target range in the middle of the year 2019 and will be 5.8% by the end of the following year. In 2020, inflation will decelerate to 5.0%, thus corresponding to the mean value of the target range (5.0% ± 1 pp).
The NBU expects economic growth to accelerate in 2018
The economic growth is to accelerate to 3.4% in 2018. The key driver of the economic growth will be private consumption associated with sustained high real wages growth rates, as well as other household incomes, including pensions. Besides, loosening the fiscal policy will be an additional contributor. Also, companies’ investment activity will stay robust.
In 2019-2020 increase in real GDP will somewhat slow down (to 2.9%) due to wearing off this year’s fiscal easing effects and impact of the tight monetary policy necessary to bring the consumer inflation to the target level over the forecast horizon. Furthermore, a slow progression of the structural reforms will withhold the advancement of long-term economic prospects.
Over the forecast horizon, resumption of lending will be slow primarily due to high risks of the institutional environment, suchas the low level of protection of creditors’ rights.
The role of exports in the economic growth will gradually strengthen complementary to favorable trade conditions and expanding access to foreign markets. The export increase will also sustain recovery of manufacturing in certain industries that lost supply of products manufactured by companies in non-government controlled area in the previous year. At the same time, boosted domestic consumption and investment demand will continue to drive imports. Thus, the current account deficit will maintain the level of about 3% of GDP in 2018–2020.
A key assumption of the macroeconomic forecast is that Ukraine will continue to cooperate with the International Monetary Fund. This will sustain access to official funding from other organizations, as well as access to international capital markets in the forecast horizon.
This year the NBU expects about USD 2 billion tranches from the IMF, as well as the EU and the World Bank loans to be issuedto the government. The aforesaid will ensure an increase in international reserves up to USD 20.5 billion (covering 3.7 months of future imports) by the end of 2018. However, in 2019-2020, due to spiking reimbursement of the external public debt, the deficit of overall balance of payments and a drop in international reserves is expected.
A lack of the structural reform essential to maintain macrofinancial stability and continue cooperation with the IMF poses the main risk to the implementation of the mentioned scenario, according to the regulator. In case of premature termination of the IMF program, it may impede Ukraine’s access to the international financial markets, which may bring higher currency depreciation and inflation expectations and raise probability of facing problems with external public debt servicing in the next years. In 2018-2020, the Government and the NBU have to pay more than USD 16 billion for external debt servicing. Hence, the NBU deems further cooperation with the IMF within the existing and new programs to be critical for maintaining macrofinancial stability.
Another considerable risk stems from a looser fiscal policy of the Government. In particular, faster growth in social spending than in labor productivity may aggravate the inflationary pressure. If this should be the case, the NBU will have to resort to creating tighter monetary conditions than in the baseline scenario.
With the aim of gradually bringing inflation to its targets and taking into account the above risks the NBU deems it necessary to hike the key policy rate, up to 16% per annum.
In the absence of indications of the lowering inflationary pressure the NBU may further increase the key policy rate to return inflation to its medium-term target.
The decision to raise the key policy rate to 16% is approved by NBU Board Decision No. 43-D On the Key Policy Rate, dated 25 January 2018.
А new detailed macroeconomic forecast will be published in the Inflation Report on 1 February 2018.
The next meeting of the NBU Board on monetary policy issues will be held on 1 March 2018 as scheduled.