Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 18 September 2024

Meeting date: 18 September 2024

Attendees: all 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
• Oleksandr Arseniuk, Acting Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department.

MPC members discussed the balance of risks to inflation and economic development, and the parameters of monetary policy instruments that will enable the NBU to return inflation to its 5% target in the coming years, maintain the sustainability of the FX market, and avoid monetary financing of the budget

In recent months, the growth in consumer prices has accelerated as expected and has been close to the NBU’s forecast, the MPC members said. However, core inflation rose more significantly than projected. Such price developments were primarily driven by this year’s lower harvests, an increase in companies’ costs of raw materials, power, and labor, and the effects of the hryvnia’s exchange rate depreciation.

Meanwhile, the inflation expectations of both households and financial analysts remained quite sustainable. Respondents expect moderate, single-digit inflation to persist this year and the next. The sustainability of inflation expectations is an important factor in restraining price pressures, as are the moratorium on tariff increases for certain utilities and the NBU’s interest-rate and exchange rate policy measures.

To keep expectations under control and restrain price pressures, the NBU maintains an active presence in the FX market, among other steps. The NBU’s FX and verbal interventions in July–August calmed the FX market and helped reduce fluctuations in the hryvnia’s exchange rate. And although there was a certain decrease in rates on hryvnia instruments in previous months, a sufficient yield on these instruments drove the demand for them.

The NBU’s capacity to ensure the sustainability of the FX market continues to be strong. Thanks to external financing, Ukraine’s international reserves exceeded USD 42 billion in August. The outlines of foreign aid in the coming years have been gradually taking shape after the fifth revision of the IMF-supported EFF program resulted in a staff-level agreement and progress was made on working out a mechanism to transfer proceeds from frozen russian assets to Ukraine.   

However, inflation risks remain significant amid war. Those include the financing of a significant deficit of the state budget. Given the need to maintain defense capabilities, budget expenditures this year and the next are likely to be higher than previously anticipated. The key to financing these expenditures is not only the preservation of significant foreign aid inflows, but also more active use of domestic funding, including through tax rises and increased borrowing in the market for domestic government debt securities. This will make it possible to avoid a repeat of monetary financing.

Ten MPC members called for holding the key policy rate steady at 13% in September

To meet one of the NBU’s important commitments as per its strategic documents, these discussion participants agreed that a key policy rate of 13% will be sufficient for households to retain their ability to protect their hryvnia savings from losing value to inflation. This will shore up the FX market’s sustainability, keep expectations in check, help maintain moderate inflation this year, and make inflation reverse into a downtrend next year and slow to its 5% target going forward. 

On the one hand, inflation expectations currently appear quite resistant to price and exchange rate developments, and real rates on hryvnia term instruments exceed both current and expected inflation. On the other hand, forecasts are showing that price pressures have yet to peak out, meaning that some deterioration in expectations in the short run is likely. This may adversely affect the attractiveness of hryvnia savings. In these conditions, holding the key policy rate steady is a reasonable and predictable decision that should safeguard hryvnia savings from being eroded by inflation. In addition, such a decision follows the trajectory of the July macroeconomic forecast, the NBU’s previous forward guidance, and market participants’ expectations.

Given the current balance of risks to price and exchange rate developments, there is no reason to resume the cycle of key policy rate cuts in September, several MPC members said. Specifically, certain positive signals have emerged, such as decreasing uncertainty over international aid, easing external price pressures as inflation cools in Ukraine’s main trading partners, and declining global energy prices. Furthermore, the situation around power shortages has turned out somewhat better than previously thought, slowing the speed at which additional business costs pass through to consumer prices. However, significant inflationary risks persist. This year’s harvests may come out lower than projected, fueling food inflation. Further russian attacks on energy infrastructure could exacerbate energy shortages and increase pressure on business costs, especially during the heating season. What is more, if port infrastructure were to take severe damage, exports would decrease, triggering proportionate consequences in the form of lower FX earnings and a shrinking FX supply.

One MPC member said that a significant – perhaps even underestimated – inflationary risk is the growing shortage of workers in the labor market. Mobilization to the Armed Forces of Ukraine continues and migration has picked up amid russia’s intensified attacks on energy and civil infrastructure, making the lack of people an increasingly pressing issue for businesses. This is putting additional pressure on prices as companies are spending more to find new employees and raise wages. Price pressures are also being fueled through the consumption channel. With uncertainty being high about the war’s duration, the labor shortage factor is becoming a source of persistent price pressures.

Another driver of inflationary pressures may be the widening of the budget deficit in 2024–2025. On the one hand, the recently passed 2025 budget law offers no way of implementing the previously discussed tax initiatives with the most inflationary impact, specifically a rise in VAT or the imposition of a war tax on business turnover. On the other hand, this only highlights the need to use other sources to finance all planned expenditures, and feeds additional uncertainty for monetary policy to grapple with.

One MPC member spoke in favor of raising the key policy rate to 13.5% in September

With inflationary pressures on the rise and budget stimulus projected to expand, the NBU should take more decisive steps towards tighter monetary conditions, this MPC member said. The month-on-month growth in households’ investments in hryvnia term deposits has halted, and although the increase in portfolios of hryvnia domestic government debt securities has resumed, it is still sensitive to exchange rate developments, this MPC member said. A slump in demand for hryvnia instruments is a very real risk, especially because the yield on hryvnia deposits is still declining by inertia, reflecting the NBU’s previous steps to loosen interest rate policy. At the same time, consumer lending is picking up, fueling consumption, of imported goods in particular, and exerting additional pressure on international reserves and prices.

In a move that would have a calming effect on expectations, a moderate rise in the key policy rate would not only make hryvnia savings more attractive, but also send a clear signal to financial markets about how the NBU prioritizes its goals and where its monetary policy is headed, this MPC member said.

MPC members also discussed adjusting the parameters of other monetary policy instruments and operations

The discussion participants agreed that because of the need to reduce the risks of monetary financing of the budget, the NBU should adjust the parameters of other monetary policy instruments and operations without posing risks to the sustainability of the FX market and the stability of prices.

All MPC members supported the proposal to raise by 5 pp the reserve requirements and expand to 60% the share of reserves the banks can cover with benchmark domestic government debt securities. Such measures will not subvert the NBU’s capacity to meet its monetary policy goals, but will spur additional demand for domestic government debt securities, boosting the government’s ability to raise enough financing in the domestic debt market.

Most MPC members also supported cutting the rate on three-month certificates of deposit (CDs) to 15.5% and trimming the rate on refinancing loans (to 16%) to enhance the banks’ flexibility in managing their liquidity and mitigate the risks of cash gaps.

By contrast, several other participants offered to make more significant (1 pp) cuts to rates on three-month CDs or actually suspend new placements of such CDs to bring about a more substantial decrease (by 2 pp) in rates on refinancing loans. Three-month CDs currently have a limited impact on market rates, in part due to intensified competition for depositors amid an increase in (consumer and other) lending and a more uneven distribution of liquidity among banks, these MPC members said. The ability to earn additional income from investing reserved funds into benchmark domestic government debt securities should also deter banks from lowering rates on hryvnia deposits. A further decrease in rates on three-month CDs or even a suspension of their placement will therefore have a close-to-neutral effect on monetary conditions, these MPC members said.

However, three-month CDs remain a significant factor in shaping monetary conditions that has a considerable impact on retail term deposit rates, most MPC members said. In particular, the banks are now actively competing for depositors in a push to make the best of the available cap on investments in three-month CDs. Previous changes in this instrument’s parameters quickly led to revisions of many banks’ interest rate policies. In fact, the uptick in high-yield consumer lending does allow some banks to maintain higher interest rates on term deposits, but this applies only to a small number of financial institutions that work in this niche. The distribution of liquidity across the system has indeed shifted somewhat, which partially affects the interest policies of primarily small banks. Overall, however, the banking system continues to be highly liquid and will remain so for a long time.

Large banks, mainly state-owned ones that enjoy the additional advantage of liquidity inflows from significant budget transfers, are generally inclined to actively reduce rates. Meanwhile, private banks, primarily small ones, have since June 2022 won back from their state-owned rivals about 25% of the market for hryvnia retail term deposits with maturities of at least 92 days by pursuing aggressive pricing policies. Such banks have become an important conduit of monetary transmission. Efforts to significantly reduce three-month-CD rates, and all the more so to shut down access to this instrument, would curtail these banks’ capacity to maintain above-market-average deposit rates. This would most likely weaken price-based competition for depositors and accelerate the decrease in the weighted average yield on term deposits. Therefore, a considerable cut in the rates on three-month CDs, and even more so a halting of their new placements, without proportionate compensators, would increase the risks of unintended loosening of monetary conditions and lead to respective consequences, these MPC members said.

Most MPC members agreed that the NBU should continue to pursue the tactics of careful calibration of operational-design parameters, taking care to monitor the effects of each intermediate step. This will make it possible to maintain optimal monetary conditions and help ensure price stability even as the war grinds on.

MPC members see no reason to resume the cycle of key policy rate cuts before the end of the year

It is necessary to refrain from lowering the key policy rate now that inflationary pressure has been rising, the participants said. Ten out of eleven MPC members expect the rate to remain at 13% until at least the end of this year. In contrast, one participant said the NBU will have to tighten monetary policy in order to restrain price pressures and maintain control over inflation expectations. This MPC member expects the key policy rate will rise to at least 14% by the end of the year.

However, all MPC members concurred that the NBU should continue to keep its finger on the pulse of the economy and flexibly adjust monetary policy if macroeconomic indicators deviate from the forecast and/or significant changes occur in the balance of risks to inflation, sustainability of the FX market, and economic development.