Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 21 July 2021

Date of the meeting: 21 July 2021.
Attendees: eight out of nine members of the NBU’s Monetary Policy Committee (MPC):

• Kyrylo Shevchenko, NBU Governor
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Vitalii Vavryshchuk, Director of the Financial Stability Department
• Volodymyr Lepushynskyi, Director of the Monetary Policy and Economic Analysis Department
• Yurii Polovniov, Director of the Statistics and Reporting Department. 

During the meeting, the MPC members paid special attention to the further strengthening of inflationary pressures in general and underlying inflationary pressures in particular, the dynamics of inflation expectations, and the need to strengthen the NBU’s monetary policy to return inflation to 5% in 2022. 

Inflation in June 2021 remained at 9.5%, but it continued to be higher than in the NBU’s previous forecast (April 2021 Inflation Report), the discussants pointed out. On the one hand, these inflation developments were largely due to temporary factors, including the effect of a low comparison base and high global prices for energy and food. The negative impact of the pandemic on supply chains remains a significant cause of global price increases. On the other hand, underlying inflationary pressures also intensified markedly. Specifically, core inflation accelerated to 7.3% yoy and also significantly exceeded the forecast (6.8%), in part due to the further growth in business expenditures on raw materials and wages and because of sustained consumer demand. 

The updated macroeconomic forecast (July 2021 Inflation Report) predicts a more significant acceleration of price growth. In the near future, inflation will exceed 10%. It will begin to slow only at the end of the year. Inflation will approach its 5% target in H2 2022, slightly later than was projected in April.

Pro-inflationary risks prevail on the monetary policy horizon, the MPC members agreed. In particular, commodity prices will be higher than expected as the global economy rapidly recovers. At the same time, a more significant acceleration of prices in most countries increases the risks of higher imported inflation. 

Robust domestic demand, which will persist throughout the policy horizon, will also be a significant pro-inflationary contributor. Businesses are improving their financial performance, while real incomes of households are increasing. As a result, business and consumer sentiment will continue to improve, also putting pressure on prices.  In addition, businesses and individuals have adapted to operating under quarantine, making it unlikely for a potential tightening of quarantine measures to have a strong disinflationary effect. 

The changes in inflation expectations seem rather contradictory. In particular, expectations have recently improved in most groups of respondents. However, this improvement is probably due to the seasonal fall in prices of certain food products and the strengthening of the hryvnia. An inflation rate higher than 10% would pose risks that inflation expectations may worsen, especially for households. Businesses in all sectors continue to expect higher prices for their products and services amid rising costs of raw materials and components. 

Six members of the MPC called for raising the key policy rate to 8%.

Clear signals have emerged since the previous MPC meeting that inflationary pressures, especially underlying inflationary pressures, will continue to rise. These signals indicate the need to increase the key policy rate, the MPC members agreed. The updated macro forecast predicts that inflation will be above the upper bound of its target range for most of 2022. 

Despite a certain improvement in inflation expectations in recent months, the central bank is obliged to respond to the increase in underlying inflationary pressures, several MPC members emphasized. Inflation expectations are adaptive, meaning that the risk that they will get out of control is still significant.

At the same time, a gradual increase in the key policy rate would be a more reasonable decision under current conditions, as opposed to a sharp hike that may be misinterpreted as an emergency measure, several other discussants said. Raising the key policy rate by 0.5 pp in July would better meet the expectations of market participants and would not trigger unnecessary shocks. By announcing its forecasts for further rate hikes in advance, the regulator will enable the market to prepare for its September decision. 

The July increase of 0.5 pp will be accompanied by other measures to strengthen the NBU’s monetary policy. Those include: changes in the operational design of the monetary policy, a reduction of the planned volume of interventions to purchase foreign currency, and a continued rollback of emergency monetary measures. 

Even in case of a more decisive increase in the key policy rate, bank deposit rates would not respond quickly, one MPC member said. This is due to abundant liquidity in the banking system and a significant share of state-owned banks in the deposit market, this MPC member said. Although interest rates are relatively low, state-owned banks can still expand their deposit base without having to raise these rates, meaning that these banks will be in no rush to offer higher rates. As market power is concentrated in these banks, other banks will likely pursue the same policy. With this in mind, it will be more effective to increase the key policy rate gradually, while communicating clearly that the NBU prioritizes achieving its 5% inflation target in 2022. 

Going forward, the NBU should also be ready for a scenario with more significant external inflationary pressures, another discussant said. Commodity market prices will remain high amid a rapid recovery in the global economy. Oil prices, for instance, continue to hover around USD 70 per barrel despite OPEC’s claims that it has ramped up production. Such supply shocks will create a negative backdrop for inflation expectations. 

Two MPC members called for hiking the key policy rate to 8.5%. 

Pro-inflation risks in both Ukraine and the world only increased each time the NBU revised its macro forecast, one of the discussants pointed out. Furthermore, central banks have begun to roll back their stimulus measures. Given all of these factors, the value of money globally will gradually rise, as will inflationary pressure on EM countries. To make matters worse, expectations will deteriorate should inflation in Ukraine breach the psychological limit of 10%. In view of this, the NBU is justified in taking a tougher preventive monetary policy approach. 

A one-percentage-point increase in the key policy rate would give the market a clearer signal that the central bank is serious about tightening its monetary policy to ease inflationary pressures, especially after keeping the rate unchanged last time, another MPC member suggested. This signal would incentivize banks to more quickly review their interest rate policies, ultimately strengthening the monetary policy transmission mechanism. 

Curbing inflationary pressures will require a further strengthening of the regulator’s monetary policy, the MPC members agreed as they discussed the forecast trajectory of the key policy rate. 

Most MPC members expect that by the end of the year, the NBU will have to raise the key policy rate by another 0.5 pp and keep it unchanged until about Q2 2022. Amplified by the other monetary policy tightening measures noted above, this will help control inflation expectations, ease inflationary pressures, and bring inflation to 5% in 2022. 

In contrast, one of the discussants noted that in order to return inflation to its target, the NBU may need to hike the key policy rate more substantially, up to 9%.  

The decision to set the key policy rate at 8% per annum was approved by the NBU Board at the monetary policy meeting held on 22 July 2021.