Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 14 June 2023

Date of the meeting: 14 June 2023.
Attendees: 10 out of 11 members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine: 

• Andriy Pyshnyy, Governor of the National Bank of Ukraine
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Dmytro Oliinyk,  Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director, Financial Stability Department
• Volodymyr Lepushynskyi, Director, Monetary Policy and Economic Analysis Department
• Yuriy Polovniov, Director, Statistics and Reporting Department.

Members of the MPC discussed the sustainability of the downtrend in inflation, the effectiveness of the NBU’s previous measures to increase the attractiveness of hryvnia assets, and the impact of russian terrorist attacks against critical infrastructure on economic and inflation developments.

The slowdown in inflation in recent months has been faster than the NBU expected, the MPC members said. Specifically, inflation declined to 15.3% in May, down from the 16.2% yoy rate predicted by the trajectory in the April forecast. Although headline inflation slowed, underlying inflationary pressures remained rather high. Among other things, they were driven by the pass-through of war-related costs to the prices of goods and services. As a result, core inflation decreased to only 15.6% yoy in May, matching the NBU’s forecast. By NBU estimates, the pullback in inflation continued in June. These dynamics were partially driven by the base effect. An increase in the supply of food and fuel also had a positive impact. In addition, more quickly than expected, the economy overcame the energy crisis caused by russian missile terror, easing pressure on businesses’ costs.

At the same time, the strengthening of the hryvnia in the cash segment of the FX market, including due to the NBU’s comprehensive measures, made a significant contribution to the improvement in price dynamics. The steps taken by the central bank include the maintenance of the key policy rate at 25%, the tightening of reserve requirements, and the updating the operational design of monetary policy. These measures resulted in the accelerated increase by the banks of interest rates on hryvnia deposits, and the growth of term deposits in all groups of banks. The share of retail term deposits in the banking system has expanded by almost 5 pp since the beginning of the year, to more than 35%. The proportion of 3-to-12-month deposits in the volume of new deposits increased to 76% in May from 47% at the beginning of the year. The improved investment appeal of hryvnia assets had a positive effect on both the FX market and exchange-rate and inflation expectations of most groups of respondents.

As a result, the NBU’s interventions to sell foreign currency decreased substantially in the spring compared to the level the NBU expected. Furthermore, thanks to sustained external support, Ukraine’s international reserves grew to USD 37.3 billion at the beginning of June. This has reinforced the NBU’s capacity to ensure the sustainability of the FX market going forward.

Although certain positive trends have emerged, pro-inflationary risks remain elevated, including due to the security situation. Specifically, russia continues to perpetrate terrorist attacks on Ukraine’s critical infrastructure. By NBU estimates, the destruction of the Kakhovka dam will add about 0.3 pp to this year’s inflation rate because of how this russian-made disaster has complicated the operation of multiple businesses and due to the partial loss of vegetable crops.

The grain corridor has been operating with disruptions, and russia is constantly blackmailing the world by making threats to close the passageway down. Should such a scenario materialize, it will have adverse consequences for Ukrainian exports, reducing FX inflows to Ukraine and potentially driving up pressure on the hryvnia to depreciate. Restrictions that some EU countries have limitations imposed on imports of Ukrainian-made food can make the situation worse.

What is more, the inflation forecast is vulnerable to multiple domestic risks. Inflation dynamics may deteriorate due to changes in pricing in the electricity market for consumers other than households. A quicker-than-expected recovery in economic activity may also put certain pressure on prices. In addition, current account balances in banks continue to stand at an all-time high (of almost UAH 400 billion in retail funds), posing risks to the FX market if restrictions are eased further. In this regard, it remains relevant to maintain the effects of previous measures to ensure that hryvnia assets are sufficiently attractive.

Seven MPC members called for maintaining the key policy rate at 25% in June.

The transmission mechanism’s improved performance and households’ increased interest in hryvnia-denominated term instruments represent a significant important achievement, some of these MPC members noted. However, the effects of implemented measures have yet to exhaust their potential. In particular, in the three years leading up to the full-scale invasion, term deposits accounted for an average of about 50% of total retail deposits. Provided that hryvnia savings remain sufficiently lucrative, this indicator still has plenty of room to grow from the current 35%. The improvement in the term structure of deposits will continue to mitigate threats to exchange rate sustainability and underpin a steady decline in inflation.

However, to make the most out of the introduced measures’ potential without reversing the positive trends, it is necessary to proceed with caution.

Specifically, to avoid creating additional uncertainty in the financial market, the NBU should pursue a consistent and predictable policy, two MPC members said. Surveys have shown that keeping the key policy rate unchanged is a decision that is currently anticipated by most financial experts. On the other hand, if the NBU were to unexpectedly cut its key policy rate, it would erode the effectiveness of the previously implemented measures, including by dampening the banks’ incentives to compete for hryvnia deposits.

Another MPC member said that the transmission of a reduction in the key policy rate to the return on deposits and domestic government debt securities would likely be quick and strong. However, speaking from experience, it would be extremely difficult to reverse this trend by making emergency rate increases to preserve financial stability if the situation were to seriously deteriorate. Such an emergency cannot be ruled out given the unpredictable nature and intensity of the full-scale war and the record amount of funds in current accounts.

Several other participants in the discussion agreed with this MPC member. They pointed to the heightening of a number of risks associated with the war and said that the risks had partially materialized since the last meeting. Among other things, russia’s terrorist attack on the Kakhovka HPP will have a pro-inflationary effect, at least in the short run. At the same time, the mid-term and long-term fallout from this manmade disaster has yet to be fully assessed. As russia continues to perpetrate acts of terrorism, a scenario in which the grain corridor is completely and irreversibly terminated cannot be discarded.

A threat still exists that additional budgetary needs and significant quasi-fiscal deficits may emerge, one of the participants in the discussion said. The April update to the forecast trajectory of the key policy rate resulted in investors taking greater interest in domestic government debt securities. Coupled with the government’s and the NBU’s other measures, this helped intensify market-based borrowing to finance the budget deficit. This interest can be further supported by issuing forward guidance on the gradual reduction of the key policy rate as soon as during the upcoming meetings, this MPC member said.

These MPC members concurred that threats of new inflationary shocks and risks of heightened pressure on Ukraine’s international reserves remain elevated. The risks of making premature cuts to the key policy rate are therefore much greater than those of keeping it unchanged. All the more so now that the NBU has been preparing further measures to ease the FX restrictions that are most significantly hindering business development and efforts to raise resources for Ukraine’s economic recovery.

Although economic and inflation developments have shown rather upbeat trends in recent months, this optimism should not be overrated. Amid high uncertainty over the war, it is necessary to more carefully analyze the prospects for the sustainability of these positive trends. The MPC meeting in July will unveil the NBU’s updated macro forecast and provide more answers to these questions.

Three MPC members advocated reducing the key policy rate in June.

The NBU can already take first steps to cut the key policy rate without running the risk of making hryvnia assets less attractive and exacerbating threats to exchange rate sustainability, these MPC members said. Such a decision will not come as a big surprise, because surveys of market participants indicate an increase in the number of respondents who believe it is time to cut the key policy rate, these MPC members said.

Inflation has been declining much faster than the NBU’s forecast predicted, and inflation expectations are noticeably improving, these MPC members said. By the NBU’s early estimates, the impact on inflation from the destruction of the Kakhovka HPP and the increase in electricity tariffs for households will be moderate, one of the participants in the discussion said. At the same time, consumer demand remains relatively restrained, and global inflation continues to decline. Therefore, even if security risks partially materialize, the growth in consumer prices in Ukraine will continue to decelerate. As a result, the real return on hryvnia assets will grow even if the key policy rate is moderately reduced.

Another participant in the discussion concurred: even now, interest rates on hryvnia deposits are actually covering the inflation rate expected in the year ahead, and the banks are successfully taking term deposits. The banks therefore have no particular motivation to further increase rates on hryvnia deposits: this effect of the NBU’s measures has been depleted. A reduction in the key policy rate will primarily affect the return on the most profitable three-month deposits, but they will still provide sufficient protection against inflation-driven depreciation. Preservation of positive real interest rates on deposits will support the significant progress achieved by the NBU in increasing the maturity of hryvnia savings and strengthening the sustainability of the FX market.

The better-than-expected growth in international reserves, sustained international support, and the lower-than-anticipated volume of FX interventions indicate that a moderate cut to the key policy rate will not pose risks to exchange-rate and price dynamics even if FX restrictions are relaxed further, these MPC members said.

However, they differed on the size of such a key policy rate reduction. Two of them said that they had proposed to lower the key policy rate at the previous meeting and that they currently see the prerequisites for decisive steps. One of these MPC members spoke in favor of reducing the rate by 2 pp, while another suggested an immediate 5 pp cut.  Another participant offered to lower the rate by a more circumspect 1 pp.

Most MPC members do not rule out that the NBU may launch a cycle of gradual key policy rate cuts earlier than the April forecast predicted.

The majority of MPC members consider it probable that the key policy rate will decrease by 1–2 pp starting in July or September. They agreed that in the event of a further and faster-than-forecast slowdown in headline and core inflation, a corresponding improvement in expectations, and the preservation of a sufficient volume of international reserves, the NBU will be able to shift to a cycle of key policy rate reductions without running the risk of diminishing the attractiveness of hryvnia assets. However, it cannot be ruled out that the central bank may postpone such a decision if risks materialize and pose new challenges to the FX market and the Ukrainian economy.

The discussion participants also agreed that a potential flight from the hryvnia is too much of a threat to macrofinancial stability and the steady decline in inflation. Considering this, the NBU should exercise caution in its decisions and take steps gradually. As the full-scale war grinds on, the key policy rate must remain positive in real terms. Most MPC members expect that the key policy rate will be 20%–21% at the end of the year. Another participant in the discussion thinks that prerequisites exist for a sharper decrease to 19%–20%.