Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 19 January 2022

Date of the meeting: 19 January 2022.
Attendees: all ten members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Kyrylo Shevchenko, NBU Governor
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, Director, Financial Stability Department
• Volodymyr Lepushynskyi, Director, Monetary Policy and Economic Analysis Department
• Oleksii Lupin, Director, Open Market Operations Department
• Yuriy Polovniov, Director, Statistics and Reporting Department. 

During the meeting, the MPC members paid special attention to the strengthening of inflationary pressures due to both fundamental factors and growing concerns in the media about a potential escalation of Russian military aggression. Given the speed with which the situation was changing and the elevated uncertainty, the MPC members discussed multiple scenarios of the NBU’s monetary response: from raising the key policy rate by 1 pp to increasing it immediately by 3 pp. There were differences in assumptions across the scenarios, in particular about the growth of the risk premium on Ukrainian assets and the intensity of portfolio investment outflows in adverse information conditions, as well as a possible reaction by market participants, especially nonresidents, to a significant hike in the key policy rate. The lively discussion of the central bank’s optimal response continued into the meeting the next day of the NBU Board, which then made the final decision on the key policy rate (for details, see the comment*). 

During the discussion, the MPC members pointed out repeatedly that having peaked in the fall of 2021, inflation was declining, but at a slower pace than previously expected. In particular, at the end of the year it did not return to single digits and stood at 10% yoy. Core inflation accelerated to 7.9% yoy in December, contrary to the anticipated decline to 7.1% yoy. Underlying inflationary pressures in Ukraine were fueled by significant growth in real wages, which had surpassed the NBU’s forecast, in part due to labor migration and a significant worsening of labor market mismatches. Inflation affected an increasingly wide range of consumer goods and services, including through the side effects of persistent high prices for energy and food. Production costs of Ukrainian businesses, including wages and the cost of raw materials, increased and gradually fed into consumer prices. Sustained consumer demand generated additional price pressure. To make matters worse, inflation in Ukraine’s MTPs continued to accelerate, spilling over into price growth in Ukraine.

In early 2022, depreciation pressures increased sharply. High state budget expenditures in late December, coupled with the mounting concerns voiced by the media amid looming geopolitical tensions, triggered a surge of demand for foreign currency. As a result, the hryvnia weakened markedly under pressure from psychological and ad-hoc factors. The large increase in Ukraine’s risk premium was also reflected in the sell-off of sovereign Eurobonds as their quotations fell. Uncertainty over the timing of a military de-escalation is fueling additional price pressures through the expectations channel and the exchange rate channel.

The performance of the interest rate channel of monetary transmission needs to be improved, the discussants said. The banking system maintains a structural surplus of liquidity, which significantly reduces transmission, as banks have fewer incentives to compete for depositors. The weighted average cost of hryvnia funding in the banking system as a whole remains low. At the same time, there is a growing need to stimulate households’ propensity to save.

Given the current and projected inflation trends, all discussants unanimously spoke in favor of strengthening the monetary policy. They also agreed that raising the key policy rate by 0.5 pp would not be sufficient to curb inflationary pressures, even with the effects of good harvests remaining favorable and with global prices for raw materials, food, and logistics adjusting gradually. In contrast, a more decisive response by the NBU may prevent a further deterioration of expectations and the unraveling of an inflationary spiral. The anticipated return of inflation to its target in 2023 may depend on how confidently the NBU acts today. Delaying a proper monetary response will increase the risk of longer-term deviations of inflation from the target and higher rate hikes going forward.

Despite the overall consensus that the cycle of monetary policy tightening should continue, opinions differed about the optimal increase in the key policy rate.

Seven MPC members called for raising the key policy rate to 11% in January

The surge of negative news about a possible military offensive by Russia has been causing significant imbalances in market expectations, these discussants agreed.  The situation will remain tense, at least in the short run. Businesses, households, and foreign investors are sensitive to headlines mentioning Russia’s military plans. With energy prices at all-time highs, energy imports are an additional factor in fueling the demand for foreign currency. As a result, strong depreciation pressures persist, keeping Ukraine’s risk premium at extraordinarily high levels. International capital markets will stay virtually closed to Ukraine until a de-escalation occurs.

From the beginning, the preferred option was to increase the key policy rate by 1 pp, one of these MPC members said. However, the surging depreciation pressure, which is likely to stay here for some time, means that a more radical hike should be considered, this MPC member said. In the current situation, the NBU has no choice but to significantly increase the differential between interest rates on FX and hryvnia funds. It is necessary to promote the appeal of investments in hryvnia domestic government debt securities, increase the opportunity cost of speculative attacks on the hryvnia, and keep exchange rate expectations in check. Taken simultaneously, these measures will have the effect of diffusing depreciation and inflationary pressures.  At this time, the poor performance of the auctions year to date to issue domestic government debt securities indicates that, with yields at their current levels, investors are unwilling to buy hryvnia assets. As the exchange rate channel is rapidly losing its disinflationary effect, the risks to the updated inflation forecast for 2022 are shifting even further up, this MPC member said. So, a 2 pp increase in the key policy rate now would be a logical step that would allow the interest rate channel of monetary transmission to work more effectively.

Geopolitical conditions are likely to remain tense for a long time, another discussant said. Russia will continue to try to destabilize the situation in Ukraine, even without invading further into its territory. This will restrict Ukraine’s access to global capital markets for long. In making the case for hiking the key policy rate by 2 pp in a single move, this MPC member also said that inflationary pressures were exceeding the projected levels, that higher energy prices were producing second-round effects, and that competition from EM countries for financial resources had climbed to a new level.

Another MPC member agreed that the shift in global financial market conditions was strong enough to affect all EM countries. There is little doubt that the U.S. Fed and other leading central banks will raise their interest rates in the coming months. As a result, the EMs have been raising their key policy rates by 50–100 bp at a time, while the National Bank of Moldova has recently delivered a 200 bp hike. With geopolitical risks looming large, the NBU must therefore move more decisively to maintain the competitive edge of hryvnia assets. In addition to increasing the key policy rate, it is also necessary to conduct more active FX interventions.

At the same time, the current decision will be made by the NBU Board in conditions of significant uncertainty, said a discussant who supported raising the key policy rate by 2 pp.  The situation in foreign and domestic markets remains very sensitive to shifts in sentiment in the media, and has been changing on a daily basis. Under such conditions, it is necessary to take into account the possible reaction of market participants to the actions of the NBU, maintain composure, and analyze the possible consequences of further information attacks in Russia’s hybrid war against Ukraine, this MPC member said.

Two members of the MPC suggested increasing the key policy rate to 10% in January

Such a step will be more consistent and understandable for market participants, given the previous monetary decisions and communications of the NBU, they said. The inflation risks that have actually materialized were already taken into account by the NBU during previous key policy rate discussions, especially in December, they pointed out. In addition, inflation peaked in the fall of 2021 and continues to slow. The only really significant change is the deterioration of the information backdrop around a possible military offensive by Russia, which has put additional depreciation pressure on the hryvnia.

However, the current situation in the FX market should be calmed not by a sharp hike in rates, but by more proactive FX interventions and verbal guidance, one of the discussants said. Currently, things are different from 2014, as there are no fundamental factors for such a significant weakening of the hryvnia. Instead, there is a rush in the demand for foreign currency, fueled by injections of adverse information. Together with a significant revision of the forecast and the announcement of a set of measures to structurally regulate liquidity, a sharp rise in rates may be perceived as an emergency hike, which the market is not expecting. If this hike were to be made, the public could infer that the NBU possessed adverse information it did not intend to reveal, or that the NBU itself was panicking. And so instead of improving things, it would make them worse by lowering the expectations of economic agents, especially nonresidents, which have already been selling off Ukrainian assets. Alternatively, bigger FX interventions by the central bank would not only alleviate the rush to buy foreign currency, which is driven solely by psychological and ad-hoc factors, but also partially sterilize excess hryvnia liquidity from the banking system, which would also have a disinflationary effect.

An emergency hike would in current conditions look more like a belated response by the NBU, another MPC member agreed. The growth in Ukraine’s risk premium has already been priced in, and it wouldn’t make much sense to counteract it by delivering a significant increase in the key policy rate. Such a move would not return foreign investors to the Ukrainian market, as the main deterrent is still uncertainty over a military escalation, not the level of interest rates. At the same time, more active interventions by the NBU in the FX market are really necessary to improve the sentiment of households, businesses, and investors.

The NBU needs to bring the key policy rate to its neutral level at a more moderate pace, this discussant suggested. Among the arguments in favor of such a trajectory is that the growth in administered prices has been factored into the forecast for 2022 as a significant component of inflation.  It is impossible to level off administered inflation, even through a large key policy rate hike. In addition, the effect of the NBU’s previous decisions to tighten the monetary policy has already manifested itself. That includes the acceleration of the growth in market rates, this discussant emphasized.

In such conditions, raising the key policy rate by 1 pp looks like quite a sufficient and at the same time balanced step, these MPC members concluded. On the one hand, it exceeds the expectations of most market participants and will help strengthen their confidence in the regulator’s monetary policy. This is important in terms of counterbalancing the tense information background. On the other hand, such a step will not seem as emotional as would an unanticipated 2 pp hike.

One MPC member advocated raising the key policy rate to 12% in January

From one perspective, the forecast of real GDP growth in Ukraine even now looks overly optimistic, this MPC member suggested. The economy will grow much more slowly due to a number of factors: the global monetary contraction, high energy prices and related problems in certain sectors of the economy (chemicals, metals-and-mining, agriculture), geopolitical tensions around Ukraine, the further reduction in the transit of natural gas through the Ukrainian gas transport system, the global transition to the green economy, and a probable industrial downturn in the wake of the setbacks in the global commodity and financial markets, this MPC member said.

From another perspective, pro-inflation risks look even more dangerous. In the opinion of this MPC member, the updated macro forecast underestimates these risks. This will hinder the achievement of the 5% inflation target, which is the NBU’s priority on the policy horizon.

First, the active phase of Russia’s hybrid war against Ukraine has resumed and will continue. Given these geopolitical risks, Ukraine may face significant and prolonged capital outflows. Nonresidents are currently withdrawing from hryvnia domestic government debt securities at a low-key pace, but even this has brought the hryvnia under significant depreciation pressure. Provided no de-escalation occurs, the pressure on consumer prices through the exchange rate channel and the expectations channel will remain.

Second, the global tightening of monetary policies is just kicking off, and it is better for Ukraine to prepare for it in advance. The worldwide monetary contraction will hit all EMs hard, and so the NBU must act decisively. Moreover, it is likely that Ukraine’s risk premium will not decline as quickly and significantly as expected. In such circumstances, a refusal to move quickly to tighten the monetary policy threatens to accelerate the outflow of capital from the country. Ukraine therefore “needs to run faster than others, just to stay put.”

Third, energy price assumptions also seem optimistic. According to this member of the MPC, prices in commodity markets in general will fall, but it is likely that the average price of natural gas and oil will be higher than projected. This, among other things, increases the risk of a stronger impact of the second-round effects and a significant increase in prices for utilities. In such circumstances, companies will face the need to increase the salaries of their employees faster. The unraveling of the wage-price inflation spiral will also require resolute action by the NBU, but in this case we will have to tighten the monetary policy stance even more.

With these factors in mind, the NBU must take proactive measures and raise the key policy rate substantially. In addition, surges of demand in the FX market must be met with greater resolve amid the absence of fundamental depreciation drivers. This will help prevent an unbalancing of household expectations and keep the FX purchasing hype at bay. It is for such situations that FX reserves are accumulated in good times. Without a large rate hike, both the 7.7% inflation forecast for 2022 and the return of inflation to the 5% target in 2023 look unrealistic, this MPC member said.

The monetary policy stance will need to be tightened further in the months ahead to ease inflationary pressures in 2022 and bring inflation back to 5% in 2023, all MPC members agreed

The discussants expressed their commitment to act decisively should pro-inflationary factors continue to materialize. The monetary policy should be tight enough to ensure a steady decline in inflation, they said. To deliver this result, the key policy rate must be at least at its neutral level during 2022–2023. Additional rate increases will have to be made earlier than planned if the situation does not calm down, one MPC member suggested.

The introduction of a set of measures to sterilize excess liquidity from the banking system should also help decelerate inflation. Most MPC members supported the implementation of such measures in February–March. At the same time, in considering separately the issue of raising the required reserve ratio, several discussants expressed doubts about the disinflationary impact of such an instrument.