Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 13 September 2023

Meeting date: 13 September 2023.

Attendees: all 11 members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine: 

• Andriy Pyshnyy, Governor of the National Bank of Ukraine 
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Dmytro Oliinyk,  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.

The MPC members discussed the strengthening of favorable macrofinancial trends in recent months, the effects of the July reduction of the key policy rate, as well as the consistency of further steps in the interest rate policy with the implementation of the Strategy for Easing FX Restrictions, Transitioning to Greater Flexibility of the Exchange Rate, and Returning to Inflation Targeting (hereinafter the “Strategy”).

During the discussion, it was noted that consumer inflation continued to decelerate faster than expected (8.6% yoy in August). However, core inflation was close to the NBU forecast (10% yoy in August). The slowdown in inflation was largely driven by a greater supply of food products. In addition, price pressure from business costs has decreased somewhat. The further improvement in exchange-rate and inflation expectations also made a significant impact, in particular thanks to the NBU’s measures to maintain exchange rate sustainability and the attractiveness of hryvnia assets.

The launch of the cycle of key policy rate cuts in July has not prevented the demand for hryvnia assets from growing. Market interest rates edged lower during August, but remained attractive amid a sustained pullback in inflation and improving expectations. The  reserve requirement mechanism and the unconventional operational design of monetary policy continued to fuel the banks’ competition for term deposits even after the NBU lowered the interest rates. The ad-hoc increase in fluctuations on the cash FX market in August did not reverse the uptrend in households’ investments in domestic government debt securities and hryvnia retail term deposits and the downtrend in the dollarization of savings.

The NBU retained a strong capability to balance the FX market. Thanks to stable official financing, Ukraine’s international reserves remain high. In late August, they surpassed USD 40 billion. International aid enables the NBU to cover the FX deficit caused by the war. The net sale of foreign currency by the NBU came out lower than expected, and the overall situation in the FX market remained sustainable.

The discussion participants agreed that favorable macrofinancial trends are making it possible to continue the cycle of key policy rate reductions. At the same time, it is necessary to take into account the need to keep the interest rates on hryvnia instruments attractive to households. This is important both for further limiting the pressure on the FX market and prices and for continuing the implementation of the Strategy. In addition, given the significant risks, as well as the reduced potential for a rapid slowdown in inflation, the MPC members agreed that the NBU should continue to proceed gradually and with caution.

Nine of eleven MPC members suggested cutting the key policy rate to 20% in September.

These MPC members believe that a moderate reduction in the key policy rate by 2 pp will not create threats to the attractiveness of hryvnia savings, to exchange rate sustainability, to the steady decline in inflation, and to the further implementation of the Strategy. At the same time, such a step will support the recovery of the economy.

As current trends show, the gradual loosening of the interest rate policy is helping maintain investors’ interest in maximizing their gains from term instruments, both deposits and domestic government debt securities. Among other things, this is reinforcing the government’s capacity to raise funds in the domestic debt market at lower rates and for longer terms. As a result, the risk of having to resume the monetary financing of the state budget is also minimized, which is especially important as additional budgetary needs emerge to maintain defense capabilities. What is more, because the hryvnia remains attractive, the tying up of households’ hryvnia funds in term instruments continues, which strengthens the NBU’s capability to maintain the sustainability of the FX market. Under the current monetary regime, exchange rate sustainability remains the main anchor for the expectations of economic agents. Maintaining confidence in the domestic currency is therefore an extremely important objective.

At the same time, these discussion participants agreed that a sharper reduction in the key policy rate could create threats during the Strategy’s implementation. Specifically, the first response from interest rates on hryvnia retail term deposits to the launch of the cycle of key policy rate cuts was quite rapid, one of the MPC members said. This confirms the hypothesis that with a more significant reduction in the key policy rate, the banks may be inclined to lower deposit rates faster, taking into account the record surplus of liquidity, the high concentration of the retail deposit market, and the sharp drop in inflation. Such a decision could undermine the attractiveness of hryvnia savings, potentially posing risks to the Strategy’s further implementation. Favorable macroeconomic trends should be perceived first and foremost as a signal that FX restrictions may be eased further and that a transition to controlled exchange-rate flexibility may occur going forward, instead of as a reason to make more-aggressive-than-forecast cuts to the key policy rate, this MPC member said. The current situation is different from an inflation targeting regime whereby the trajectory of the key policy rate is primarily determined by the inflation forecast.

Several participants in the discussion agreed that it is important that the NBU remain conservative in view of the partial deterioration in the balance of risks. First, risks associated with the duration and course of the war persist. Second, the risk of insufficient international funding remains relevant. Third, Ukraine’s opportunities to increase exports, and therefore its FX earnings, are restrained by EU countries’ embargo on Ukrainian grain imports and by russia’s blockade of the Black Sea Grain Initiative’s full-fledged operation. In addition, several MPC members said, the wartime FX market is rather sensitive to news, and the investment appeal of hryvnia assets depends heavily not only on the interest rate, but also on exchange rate dynamics. If exchange rate expectations deteriorate significantly, with the difference between hryvnia interest rates and the rate of inflation being small, it will be impossible to contain the pressure on the FX market.

The benefit to the economy from a sharper decrease in the key policy rate is not obvious, as lending is primarily restrained by security risks, one of the discussion participants said. The banks are being cautious in their credit scoring of borrowers, while companies are being cautious in expanding current and launching new investment projects.  A faster easing of the interest rate policy would not remove the major impediments that are significantly restraining business investments: export channel disruptions, logistical routes congestion, and the narrowing of domestic demand due to migration.

At the same time, the demand for hryvnia assets may be much more sensitive to a reduction in the key policy rate. More than 60% of goods and services are still under price pressure of above 5% yoy. Inflation expectations, though somewhat more upbeat, remain higher than both the inflation target and the July forecast of the consumer price index.

In addition, several MPC members said, with the plans to further implement the Strategy and because of the current level of risks, the NBU is better off lowering the key policy rate in line with expectations, pursuing a monetary policy that is as consistent and predictable as possible and that does not deviate from previous communications. This will further mitigate wartime uncertainty, help safeguard the attractiveness of hryvnia instruments, and keep exchange-rate and inflation expectations in check.

The October meeting of the MPC, when the macro forecast is updated and a more thorough analysis of changes in the balance of risks is made, will be the best time to reassess the future trajectory of the key policy rate, if grounds for this emerge, these MPC members said.

Two MPC members said the key policy rate should be cut more significantly to 19% in September.

The faster long-term pullback in inflation than the NBU projected indicates a chronic overestimation of inflationary risks, these MPC members said. The actual macroeconomic situation has turned out much better than was anticipated at the beginning of this year. The NBU’s measures to make hryvnia assets more attractive are working, their effects persist, and so the NBU can take bolder action. Deeper-than-forecast cuts to the key policy rate will not pose threats to the attractiveness of hryvnia savings, because the current yield on hryvnia assets is more than protecting savings from inflation-related loss of value.

One of these MPC members expressed confidence that inflation will stay below 10% this year and through next year. Among other things, this will be facilitated by a decrease in domestic food prices due to good harvests and difficulty exporting these products. Furthermore, consumer prices will be subdued by the deceleration of global inflation. With this in mind, we should also expect a further improvement in inflation expectations, making more room for a slightly expedited reduction in the key policy rate.

Another participant said that although it is important to keep the monetary policy consistent, the NBU should continue to flexibly adjust to the rapidly changing situation. Specifically, in view of the faster-than-expected decline in inflation, sustained stable conditions in the FX market, and a high level of international reserves, the NBU launched a monetary easing cycle in July, sooner than the April forecast envisaged. This decision has not adversely impacted the attractiveness of hryvnia savings and has been supporting the economic recovery. The NBU should act with greater resolve and, if need be, make decisions that may not fully match the previously forecast trajectories and/or market expectations. The situation may continue to evolve too quickly due to factors that cannot currently be factored into the forecast.

These MPC members also agreed that although there is some uncertainty over international funding for next year, financial support will continue to arrive in sufficient volumes as Ukraine meets its commitments to partners. The NBU will therefore maintain international reserves at a high level and continue to be able to ensure exchange rate sustainability, including during the further easing of restrictions and when transitioning to managed flexibility of the exchange rate.

The discussion participants also spoke in favor of optimizing the parameters of the operational design of the monetary policy in order to sustain the banks’ competition for term deposits.

The MPC members highlighted the effectiveness of the unconventional operational design of monetary policy. Thanks to the introduction in April of three-month certificates of deposit (CDs), which are conditioned on the banks’ success in raising retail term deposits and which pay a higher interest rate than overnight CDs, the NBU has managed to significantly amplify the banks’ competition for depositors, and thus the monetary transmission in general. This instrument has made a considerable contribution to the growth in term deposits and their share in the overall portfolio of hryvnia retail deposits. Specifically, in January–July 2023, the volume of hryvnia retail term deposits grew by 23.4%. Their share of the total portfolio rose by 4.4 pp, to 35.3% (about 90% of these deposits having maturities of more than three months). The rate of dollarization of client deposits declined by 2.2 pp, to 34% in January–July 2023, thanks to an increase in hryvnia deposits and a decrease in the demand for FX deposits. 

The unconventional operational design of the monetary policy, along with the NBU’s other measures, compels the banks to more actively compete for term deposits even as the cycle of key policy rate cuts continues. In August, the weighted average rate on hryvnia retail deposits with maturities of more than 93 days decreased by less (0.4 pp) than that on term deposits in general (down 0.6 pp). As a result, the volume of hryvnia deposits with maturities above 93 days increased substantially that month.

In view of this, most discussion participants supported maintaining the rate differential between overnight CDs and three-month CDs at 4 pp. Such a step will stimulate the banks to further increase their volumes of term deposits instead of just letting the money sit in current accounts.

In addition, the MPC members advocated revising the percentage of retail term deposits that goes into the calculation of the cap on how much the banks can invest in three-month CDs. Most MPC members supported halving this ratio to 35% from 70%. This will encourage the banks to build up a portfolio of new term deposits to invest in three-month CDs.

All MPC members expect a further reduction in the key policy rate, but they slightly differ on how fast the easing of the interest rate policy should proceed.

The discussion participants agreed that the NBU will press forward with the cycle of key policy rate reductions, provided that inflation slows further and the FX market retains its sustainability over the forecast horizon. The easing of the interest rate policy should continue to be consistent with currency liberalization measures and the transition from the fixed exchange rate towards a regime of managed exchange rate flexibility envisaged by the Strategy, the MPC members said. At each stage of the Strategy’s implementation, the NBU must ensure that hryvnia assets are sufficiently attractive to minimize risks to exchange rate sustainability.

Most MPC members expect that the key policy rate will be reduced to 18% by the end of the year. They believe that although current macroeconomic conditions are better than previously anticipated, the NBU should also take into account the significant number of risks and a certain deterioration in the balance risks in recent months. Premature moves to ease the interest rate policy could have adverse effects on macrofinancial sustainability. If such decisions are made in error, correcting them would be time- and resource-intensive.

In contrast, several MPC members are seeing a possibility for a more significant reduction in the key policy rate, to 16%–17%, at the end of the year. Some risks are constantly being overestimated, they said. These discussion participants therefore believe that the NBU will have enough room for making a slightly deeper cut to the key policy rate than the July macro forecast provides for.