The Board of the National Bank of Ukraine has decided to raise the key policy rate to 10% per annum. As many of the pro-inflationary risks have materialized, tighter monetary policy is needed in order to improve inflation expectations and ensure steady disinflation toward the target of 5%.
Having peaked in autumn 2021, inflation has been declining. However, the decline has been slower than expected, and the underlying inflationary pressure has even increased.
Inflation declined at the end of the year thanks to the record-high harvest and a correction of some global food prices, the strengthening of the hryvnia in the previous months, the vanished low base effect, and monetary policy tightening. Inflation was also restrained by administrative decisions to fix tariffs on some utility services. As a result, consumer inflation slowed from a peak of 11% in September to 10% in December.
At the same time, a faster disinflation was prevented by a further increase in global energy prices, which passed through to prices of goods and services, and by pressures from other production costs, including labor costs. Robust consumer demand also continued to play a role. In particular, this spurred core inflation further, to 7.9% as of the end of the year.
Inflation will slow in 2022 but will return to the 5% target only in 2023.
The NBU has downgraded its 2022 inflation forecast, from 5% to 7.7%, considering the materialization of a number of pro-inflationary factors.
In particular, global energy prices will remain high for longer than expected. Not only will it put pressure on businesses’ production costs, but will also require at least a gradual correction of utility tariffs. Price pressures from trading partner countries, in which inflation is only approaching its peak, will remain strong. Second-round effects from businesses’ larger raw material expenses and labor costs will persist. An increase in demand for Ukrainian labor force, both inside the country and abroad, and qualification mismatches on the labor market will impact the growth in wages more than expected. With household income rising, consumer demand will remain robust, which will also restrain disinflation.
Moreover, a deterioration in the information environment amid geopolitical tensions that occurred late last year affected the sentiment of various groups of economic agents, putting a depreciation pressure on the hryvnia. Through exchange rate and expectations channels, this will create additional pressures on prices in the coming months.
Monetary policy tightening by the NBU, a correction of global commodity prices, and the influence of last year’s bumper crops will foster a gradual disinflation. It will be additionally driven by the easing of the global inflation surge and the waning effects of the pandemic, reflected, among other things in a larger correction of prices for raw materials, food, and logistical services.
The NBU tightening its monetary policy will also contribute to a decline in the underlying inflationary pressure. Core inflation is expected to slow to 4% in the coming years, with the administrative component making the largest contribution to the increase in consumer basket prices.
At the same time, inflation will be quite volatile in 2022 due to base effects. In addition, like in many other countries, the rise in inflation in Ukraine will last longer than expected. Taking into account the strong pro-inflationary factors and the need to continue supporting the post-pandemic economic recovery, inflation is projected to return to the target range of 5%±1 pp in mid-2023, given the monetary conditions envisaged under the baseline scenario.
GDP growth will accelerate somewhat, to 3.4% in 2022. However, high energy prices and the information environment around geopolitical tensions will restrain the economy from recovering more rapidly.
Real GDP grew by about 3% in 2021, by NBU estimates. The economic recovery was driven by sustained consumer demand, increased investment by businesses after the crisis, a record harvest of crops. However, the recovery came out slower than expected. This was in part due to a spike in energy prices and shortages, the impact of weak 2020 harvests, a slower recovery in the services sector, the limited production capacity of some manufacturing sectors, more significant losses from the pandemic, and a faster fiscal consolidation.
The forecast of real GDP growth for 2022 has been revised to 3.4% from 3.8%. The growth will be underpinned by consumer demand and still rather favorable terms of trade. On the other hand, the tense geopolitical situation will remain a significant deterrent that will adversely affect investment decisions. In addition, despite the gradual retreat of the pandemic, the consequences of the COVID-19 crisis will remain quite significant. Relatively high energy prices and shortages of certain raw materials, especially in the first half of the year, will also limit growth potential.
In 2023–2024, real GDP growth will accelerate to about 4% per year. This will be driven by the stabilization of geopolitical conditions during 2022, the fading of the fallout from COVID-19, further growth in the global economy, and the persistence of rather benign terms of trade.
It is due to favorable terms of trade that the current account deficit in 2021 was relatively small. However, it will continue to widen moderately as domestic demand increases.
The current account ran only a moderate deficit (1.9% of GDP) in 2021. This was made possible by high global prices for food and metals-and-mining products, which are Ukraine’s major exports. Yet this deficit widened rapidly in the second half of the year because of surging energy prices, weaker external demand for metals-and-mining products, and record-high dividend payments. As domestic demand from both consumers and investors revives, the current account deficit will expand further to 3.3% of GDP in 2022 and to 3.3%–3.5% of GDP thereafter.
Further progress on cooperation with the IMF will be one of the main drivers of more sustainable economic development.
IMF financing was a significant catalyst of the Ukrainian economy in 2020–2021. Cooperation with the IMF stands to be at least as important in the years ahead, especially against a deteriorating information backdrop as geopolitical tensions loom large and competition for capital between EMs and other countries intensifies amid the tighter monetary policies pursued by central banks around the globe.
Under the baseline scenario of the macroeconomic forecast, the monetary policy stance will remain moderately tight over the forecast horizon.
The key policy rate will be at least at its neutral level this year and in the coming years.
In addition, to shore up the interest rate channel of monetary transmission by managing the structural surplus of liquidity in the banking system, the NBU in February will raise by 2 pp the required reserve ratio for current accounts denominated in hryvnias and current accounts and term deposits in foreign currency. This will encourage banks to take longer-term deposits while maintaining the role of required reserves in dedollarization. In March, the central bank will also consider the issue of introducing other measures to regulate the banking system’s structural liquidity surplus.
The NBU will continue to intervene in the FX market to smooth out excessive market fluctuations. At the same time, the NBU decided, in the coming quarters, not to carry out scheduled daily interventions to purchase FX on the interbank FX market to replenish the reserves (from August 2021 these interventions amounted to USD 5 million).
Key risks to the forecast are still posed by an escalation of the military conflict with Russia and a longer and more pronounced global price surge than expected earlier.
The stoking of tensions in the media regarding the possibility of military aggression has decreased the value of Ukrainian assets and created depreciation pressures. Prolonged geopolitical tensions could have a very negative impact on the expectations of households, businesses and investors. These tensions will significantly hamper investment into the economy, while also making it difficult to raise external financing. If geopolitical risks increase, the NBU will stand ready to tighten its monetary policy.
The ongoing global spike in inflation, due to, among other things, persistently high energy and food prices, remains an important risk. In some countries, including Ukraine’s trading partners, inflation is only coming close to its peak. Looking ahead, global price movements will strongly depend on how quickly leading central banks respond to inflation challenges. Any delays will push up external price pressures. Conversely, a rapid tightening of monetary policies by leading central banks poses the risk of there being more substantial capital outflows from emerging markets.
The baseline scenario of the NBU’s forecast assumes that the impact of the pandemic on the Ukrainian economy will continue to decrease. That said, the emergence of new coronavirus variants, coupled with the still low vaccination rollout in Ukraine, poses the risk of additional economic losses in 2022. New pandemic outbreaks are unlikely to hit consumer demand hard, but will stifle business activity. This will be accompanied by rising inflationary pressures.
Other pro-inflationary risks are also important.
More specifically, a marked deterioration in terms of trade and/or a sharp decline in harvests after last year’s bumper ones could create additional depreciation pressures, while also putting greater pressures on prices.
A revival in labor migration, on the back of the gradually waning pandemic, could increase the mismatches on the domestic labor market, pushing up wage costs more noticeably and translating into rising consumer prices over time.
The speed at which administered prices change poses a separate risk. A one-off adjustment of utility prices to cost covering levels will remove imbalances in the energy sector, but will create significant inflationary pressures and worsen expectations. In contrast, any delays in taking decisions regarding utility prices will accumulate quasi-fiscal imbalances and future pressures on prices.
The NBU continues to assess the balance of risks for its baseline forecast for inflation and the key policy rate as having shifted upward, especially in the medium term.
In view of the above, the NBU will continue its monetary policy tightening cycle and stands ready to act decisively if pro-inflationary factors continue to materialize.
A new detailed macroeconomic forecast will be published in the central bank’s Inflation Report on 27 January 2022.
A summary of the discussion between Monetary Policy Committee members that preceded the approval of this decision will be published on 31 January 2022.
The next monetary policy meeting of the NBU Board will be held on 3 March 2022, according to the confirmed and published schedule.