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

Date of the meeting: 2 September 2020.

Attended by nine out of nine members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

Kyrylo Shevchenko - Governor of the National Bank of Ukraine

Kateryna Rozhkova - First Deputy Governor

Yurii Heletii- Deputy Governor

Dmytro Sologub - Deputy Governor

Oleksiy Shaban - Deputy Governor

Vitalii Vavryshchuk – Director of the Financial Stability Department

Volodymyr Lepushynskyi - Director of the Monetary Policy and Economic Analysis Department

Oleksii Lupin- acting Director of the Open Market Operations Department

Yurii Polovniov - Director of the Statistics and Reporting Department.

During the meeting, the MPC members paid a lot of attention to the increasing uncertainty about the COVID-19 pandemic and its impact on the pace of economic recovery and inflation in 2020–2021. The increase in the number of coronavirus cases in Ukraine seen in recent months has not affected the pace of the economic recovery. Nevertheless, a new wave of COVID-19 could restrain consumer demand and slow the recovery in domestic-market-oriented sectors, especially the services sector.

The inflation rate will depend on how the pandemic develops and how quickly the economy recovers. Although all of the participants said that inflation would enter its target range over the forecast horizon, they differed in how quickly that would happen.

Some MPC members believe that inflation will speed up in H2 2020, possibly deviating from the target range of 5% +/-1 pp in 2021, due to both external and internal factors. First, inflation will be driven by rebounding consumer demand and business activity on the back of the NBU’s loose monetary policy and fiscal stimuli, such as higher social standards. Second, a larger than expected rise in energy prices and a weakening in the hryvnia (compared to the same period last year), which will be gradually reflected in the prices of imported goods, will also play a role. Third, inflation in many countries that are Ukraine’s trading partners has started to accelerate, propelled by fiscal and monetary stimuli. As a result, pressures from imported inflation are gradually rising. In addition, the statistical effect of the low comparison base formed in the final months of 2019 will make a significant contribution to the overall rate of inflation.

Conversely, other MPC members said that inflationary pressures would grow only moderately in 2020 and 2021. They believe that consumer demand will remain depressed for a long time. If the epidemiological situation in Ukraine continues to deteriorate, consumer demand, which is showing signs of recovery, could become depressed again. In particular, two MPC members noted that even if quarantine restrictions were not tightened, the rising number of cases would increase households’ propensity to save, which would in turn limit consumer demand. The high level of uncertainty will also negatively affect economic agents’ investment decisions. Another MPC member said that the increase in retail trade seen in July–August could be a sign of consumers’ releasing pent-up demand built up during the period of strict quarantine restrictions. Therefore, the rate of demand recovery and related inflationary pressures that underlie the current macroeconomic forecast could be overestimated.

In view of the above, the participants said that significant uncertainty remained over the development of the coronavirus pandemic and the duration and intensity of the quarantine, as well as over the speed of recovery in consumer demand and economic activity, both in Ukraine and in the rest of the world.

Given the current balance of risks and the high level of uncertainty, all MPC members agreed that the NBU should leave the key policy rate unchanged in September, at 6% per annum.

Other arguments put forward by the participants in the discussion also supported this decision. In particular, the MPC members unanimously agreed that previous key policy rate cuts had not yet been fully transmitted to bank deposit and loan rates. The transmission is continuing, while the gap between the current key policy rate and bank rates, such as interest rates on short-term deposits, shows that there is room for further decrease in interest rates. The continuation of this process will promote lending and contribute to a faster economic recovery.

The participants said that even if the key policy rate was left unchanged, the NBU’s monetary policy would remain expansionary, while also supporting further cuts in bank interest rates. The softness of monetary policy is evidenced by the fact that the real key policy rate is being maintained below its neutral level and close to zero.

Moreover, weighted average interest rates on hryvnia deposits remain above the key policy rate. In this light, investing in risk-free assets is losing its attractiveness to most banks, which will encourage them to decrease interest rates further and to ramp up lending.

Most MPC members believe that the deterioration in the inflation expectations of households, businesses and financial analysts seen in August is another reason for keeping the key policy rate unchanged. The expected inflation rate is significantly higher than the NBU’s inflation target. Under such conditions, continued key policy rate cuts could unbalance inflation expectations further and, consequently, could increase inflationary pressures.

Some MPC members expressed the view that given high inflation expectations and a significant shift in preferences in favor of more liquid assets (such as cash and current deposits rather than time deposits), any further key policy rate cuts would only have a limited effect. The banks are likely to refrain from lowering interest rates on time deposits for fear of their outflow, and a further deterioration in the maturity composition of funding.

The banks have also reported less optimistic expectations for the quality of their loan portfolios. As a result and in the absence of any noticeable progress in strengthening the protection of creditor rights, the banks will factor in higher risks when setting their rates.

In addition, the participants agreed that any further cuts in the key policy rate could generate significant risks. More specifically, several MPC members said that the dramatic cuts in the key policy rate seen in the current year had decreased the difference between interest rates on hryvnia and FX deposits. Given the growing uncertainty and deteriorating exchange rate expectations, any further narrowing of the interest rate differential could put pressures on the exchange rate and increase the dollarization level in the economy.

In addition, any continued easing of monetary policy will cause the real key policy rate to turn negative, which could unbalance inflation expectations and discourage investors. This will also have a negative impact on the banks’ profitability and financial stability.

One of the MPC members said that currently the NBU and market participants had the same views on the development of the macrofinancial situation and the corresponding response of monetary policy. The central bank's verbal interventions are being effectively reflected in analysts’ forecasts. The findings of the latest surveys show that most analysts expect no change in the key policy rate in September and until the end of 2020. At the same time, they forecast an increase in the key policy rate in 2021 with a view to bringing consumer inflation back to its target range. In this light, any continued cuts in the key policy rate could disorient market participants and negatively affect their confidence in the monetary policy conducted by the Ukrainian central bank.

All MPC members agreed that the NBU’s future monetary policy would mainly depend on how the COVID-19 pandemic develops. The NBU will be able to provide the economy with additional impetus for growth if the adverse effect of the coronavirus pandemic on consumer and investment demand increases. Conversely, the NBU will deploy monetary policy tools to respond to the likely increase in inflation risks in 2021.

The decision to set the key policy rate at 6.0% per annum was approved by the NBU Board at a monetary policy meeting held on 3 September 2020.