Dear colleagues,
I would like to inform you that the NBU Board has decided to hike its key policy rate to 17% per annum, effective from 2 March 2018. The fourth consecutive increase in the key police rate is reasonable as inflation risks do not tend to subside. The hike is aimed at lowering headline inflation to meet the target over the medium term.
Let’s take a look at the trends at the start of the year.
In January 2018, headline inflation accelerated to 14.1% yoy, exceeding the NBU forecast published in the January Inflation Report. According to preliminary estimates, inflation rate remained high in February.
This was due to the faster-than-expected growth in food prices. Prices for raw foods gained 23.6% yoy in January. Prices for most of the "borshch vegetables" grew at an accelerated pace. Growth rates of prices for greenhouse vegetables, most of which are imported, also exceeded the expectations.
Prices of meat continued to grow. Although global meat prices have been decreasing over the past few months, internal factors played a dominant role: supplies of certain types of meat declined after the end of the holiday season while export volumes remained high.
Moreover, higher prices for fuel contributed to the actual inflation at above the expected level in January. Fuel prices increased 21.8% in January as global oil prices grew substantially and hryvnia depreciated in the past months.
Prices of services also grew markedly, by 15.2% yoy. Specifically, prices for housing maintenance, cable television and internet, and healthcare services rose noticeably.
In January, core inflation accelerated to 9.8% yoy. This was driven by a number of factors: higher production costs amid further rapid wage growth, hryvnia depreciation over the several previous months, and accelerated consumer demand.
Monetary policy tightening conducted by the NBU since October 2017 curbed the buildup in inflationary pressure. As expected, higher key policy rate has stimulated growth in bank interest rates and made hryvnia financial instruments more attractive.
In particular, this has boosted foreign capital inflows into hryvnia-denominated government securities. As from the start of the year, nonresidents’ portfolios of hryvnia domestic government bonds have more than doubled to UAH 13.1 billion from UAH 5.1 billion.
It is worth mentioning that short-term capital inflows might, under certain conditions, be quite volatile and pose risks to the external sustainability of the economy. However, the NBU currently assesses these risks as low.
First, capital inflows from nonresidents account for an insignificant share of domestic government bonds in circulation – only 1.8%. In addition, the NBU uses capital inflows to increase international reserves, i.e., a safety cushion to cover a possible capital outflow.
Second, the NBU follows the floating exchange rate regime. By allowing the exchange rate to strengthen in the periods of prevailing supply of foreign currency, the central bank discourages speculative capital investment into the country as it provides no guarantee for the exchange rate to remain at the level that is favorable for the hot capital. This is completely different from the fixed exchange rate.
Third, capital inflows currently come into government debt instruments only. Alongside, most risks related to inflows of short-term debt capital stem from inflows into the private sector, leading to overheated consumer demand.
Fourth, the inflows come into hryvnia debt instruments, which minimizes foreign exchange risks and the economy’s vulnerability to external factors.
Lets us return to inflation or, to be more precise, to one of its major drivers – foreign exchange market conditions.
An inflow of foreign capital, together with an increase in exporters’ foreign currency earnings amid benign global environment favorably affected the supply on interbank FX market. This strengthened the exchange rate of the hryvnia to the US dollar.
However, the strengthening of hryvnia against US dollar took place in parallel with the weakening of the latter on the international foreign exchange market. Therefore, the overall movements in the hryvnia exchange rate against the currencies of Ukraine’s main trading partners are not yet conducive to a faster drop in inflation.
In this light, the NBU believes that the January forecast that inflation will retreat to 8.9% in 2018 and will return to the target in mid-2019 remains relevant.
Why did the central bank decide to raise the key police rate despite little changes in its projections?
The reason is that the inflation risks the NBU considered when making its policy decision in January have persisted.
First, despite the ruling the Stockholm arbitration court made yesterday in favor of Naftogaz, the Ukrainian economy remains very vulnerable as the next tranche under the EFF program with the IMF is further postponed. Although international reserves will undoubtedly benefit from the victory of Naftogaz of Ukraine, the victory per se does not remove the need for the recommencement of cooperation with the IMF and reforms.
Second, the inflation expectations of economic agents continue to be high, exceeding the NBU’s inflation targets.
Third, consumer demand is growing rapidly.
This is in particular evidenced by the January 9.6% yoy growth in retail turnover. This was largely attributed to higher social standards, both pensions and wages. In January, nominal average wages grew fast – by 28.4%. This was in part due to a 16.3% increase in the minimum wage seen from the start of the current year. Another driver was the revision of remuneration conditions by some state-owned companies.
Meanwhile, with inflation pressure increasing, the growth in real wage slowed to 12.3% yoy. This provides further evidence that there is a need to rein in inflation to protect the income of Ukrainians from the loss of value.
When making its last policy decision, the NBU Board said that if there were no clear signs of lowering inflation pressure in the near future, the central bank might tighten its monetary policy further in order to bring inflation back to its mid-term target.
In view of the need to offset the influence of these risks and to curb inflation, the NBU has decided to increase the key policy rate to 17% per annum.
What kind of monetary policy is expected in the future?
As a result, the NBU believes that after several policy rate increases, which began in October 2017, the current monetary conditions are sufficiently tight to bring inflation back to its mid-term target, as projected in the January 2018 Inflation Report.
However, if fundamental inflation risks increase further, the NBU may resort to further key rate hikes. The next key rate decision, which will be taken in April 2018, will factor in new macroeconomic projections, inflation projections in particular.
The NBU Board is convinced that achieving price stability is a precondition for sustainable economic growth. In particular, an improvement in inflation expectations is the main driver for loan interest rates to decrease in the mid-term.
The next meeting of the NBU Board on monetary policy issues will be held on 12 April 2018.
Thank you for your attention!