Summary of the Key Policy Rate Discussion by the NBU Monetary Policy Committee

Date of the meeting: 21 October 2020
Attendees: All ten members of the NBU Monetary Policy Committee (MPC):

• Kyrylo Shevchenko - Governor of the National Bank of Ukraine
• Kateryna Rozhkova - First Deputy Governor
• Yurii Heletii - Deputy Governor
• Yaroslav Matuzka - Deputy Governor
• Dmytro Sologub - 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
• Oleksii Lupin - Director of the Open Market Operations Department
• Yurii Polovniov - Director of the Statistics and Reporting Department. 

At the meeting, the MPC members paid special attention to the prospects for economic recovery and the specifics of inflation in the face of the worsening COVID-19 situation in both Ukraine and the world. Since the September meeting, uncertainty over the course of the pandemic and its impact on the economy has increased significantly, all of the MPC members pointed out. The global economy is continuing to recover, but the spread of COVID-19 is inhibiting the process. With the prevalence of the disease rising, European countries have gradually tightened their quarantine restrictions. Some of these nations have gone back into lockdown. Tighter quarantine restrictions and the change in how economic agents make their consumer and investment decisions could result in a more significant and longer-lasting cooling of both the global and Ukrainian economies, which will restrain the growth in prices. At this time, however, it is difficult to properly assess the duration and strength of the pandemic’s impact on economic and inflationary developments. It is also impossible to predict how the coronavirus will impact price dynamics in the financial and commodity markets.

In addition, there is heightened uncertainty in Ukraine over the parameters of fiscal impulses this year and next year, and over when the nation will receive aid tranches from international financial organizations. Depending on the scenario, these factors can significantly affect inflation dynamics in 2021–2022.

Aware of the significant risk that the pandemic may impact the economy, most MPC members nonetheless expect that consumer demand and business activity will continue to recover. Coupled with the effects of the weakening of the hryvnia and the rise in energy prices, this will drive consumer prices higher. The low comparison base will also have a notable statistical effect on annual inflation estimates. As a result, inflation is expected to accelerate to 4.1% at the end of this year, and will temporarily breach the upper limit of the target range in H1 2021.

Given the heightened uncertainty and the symmetrical balance of inflation risks, the NBU in October should keep the key policy rate unchanged, at 6% per annum, nine MPC members agreed. 

In September, consumer inflation remained below its forecast due to a decrease in prices for highly volatile CPI components that do not depend on monetary impact, while core inflation matched the predicted trajectory and was set to grow. Despite current inflation rates being low, economic agents are also forecasting price increases. The inflation expectations of all groups of respondents exceed the target range, and are continuing to worsen. Given than in increase in inflationary pressures is likely in 2021, the NBU should not cut the key policy rate further. 

The MPC members also assumed that elevated uncertainty in the economy and deteriorating expectations would prevent banks from actively lowering interest rates on deposits and loans. Households’ inflation expectations for the next 12 months approached the level of interest rates on hryvnia-denominated one-year retail deposits. This limits the ability of banks to reduce interest rates without causing a deterioration in the term structure of funding, as depositors begin to prefer shorter-term deposits or demand deposits. 

Expectations of banks as to how the quality of the loan portfolio will change remain negative. The risk premium in the structure of loan rates has thus increased. The link between the key policy rate and the rates on domestic government debt securities in the primary and secondary markets has also been weakening. Yields on government securities, both long-term and short-term, have increased markedly. 

Sovereign risks have recently risen significantly, several MPC members believe. In particular, market participants are concerned about possible delays in receiving the next tranche from the IMF. Thus, lowering the key policy rate in real terms further into negative territory will increase the risk of capital outflows from the country. 

In these conditions, even by significantly reducing the key policy rate, the NBU is unlikely to convince market participants that the key policy rate will remain low in the medium and long term. Specifically, market participants expect that the key policy rate will remain at the current level until the end of 2020, and that it will increase in 2021, an October survey showed. In conditions of significant uncertainty, if the central bank were to cut the key policy rate contrary to expectations, this would give the market the wrong signal. Doing so would further increase uncertainty, which in turn would worsen inflation and depreciation expectations and have a negative effect on public confidence in monetary policy. As a result, market confidence in the effectiveness of the NBU’s monetary decisions and policies would weaken. Accordingly, the transmission of the key policy rate cut to interest rates on hryvnia instruments would be insignificant or would even be reversed, and thus the real economy would gain no positive effect from the decision.

This is why, in order for interest rates to decrease further, it is increasingly more important to step up cooperation with the IMF and other international partners, to continue to pursue a moderate fiscal policy, to make progress in reforming the judiciary and law enforcement agencies, to strengthen protection of creditor rights, and to de-shadow the economy, the MPC members said.

However, while keeping the key policy rate unchanged, the NBU acknowledges that inflation may temporarily exceed the target range in 2021. This will give the regulator wiggle room to use monetary incentives for economic recovery, the MPC members emphasized. In real terms, the key policy rate will remain below its neutral level for a long time.

One MPC member advocated cutting the key policy rate by 0.25 bp, to 5.75%. 

The worsening of the pandemic and the possible tightening of quarantine restrictions will depress household incomes and significantly hold back the already uneven recovery of domestic demand and economic activity, this MPC member said. This will have a powerful disinflationary effect, which will outbalance the influence of other factors. Accordingly, inflation should not be expected to accelerate significantly over the policy horizon. In these conditions, the NBU has sufficient leeway to cut the key policy rate to support the economy.

The growth in yields on domestic government debt securities is not something the NBU should take into account when making its key policy rate decisions, this MPC member said. The central bank targets the short end of the yield curve, while changes at the long end of the curve are driven by completely different factors that do not necessarily correlate with changes in the key policy rate. Currently, the short end of the yield curve for domestic government debt securities is close to the key policy rate, whereas the long end primarily responds to market expectations that the supply of domestic government debt securities will be significant until the end of this year and in the future.

The MPC members were divided over the projected trajectory of the key policy rate.

Given the expected increase in inflation risks over the forecast horizon, the key policy rate should be kept at the 6% level until the end of 2020, most MPC members suggested. In 2021, the NBU may switch to raising the key policy rate, they said. However, other MPC members expect that the worsening of the pandemic will force the NBU to stimulate economic activity by cutting the rate further in December this year.
That said, the NBU’s future monetary policy will mainly depend on how the pandemic evolves, on whether Ukraine makes progress in terms of its cooperation with IFIs, and on what budgetary parameters the government approves, the MPC members agreed. If the pick-up in domestic demand and business activity proves unsustainable, the NBU will give the economy additional monetary stimulus. If, on the other hand, inflationary pressures become excessively high, the NBU stands ready to raise the key policy rate.

The decision to set the key policy rate at 6.0% per annum was approved by the NBU Board at the monetary policy meeting held on 22 October 2020.