Summary of Key Policy Rate Discussion by NBU Monetary Policy Committee on 20 October 2021

Date of the meeting: 20 October 2021.
Attendees: all ten members of the Monetary Policy Committee (MPC) of the National Bank of Ukraine:

• Kyrylo Shevchenko, NBU Governor
• Kateryna Rozhkova, First Deputy Governor
• Yuriy Heletiy, Deputy Governor
• Sergiy Nikolaychuk, Deputy Governor
• Yaroslav Matuzka, Deputy Governor
• Oleksii Shaban, Deputy Governor
• Pervin Dadashova, 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
• Yuriy Polovniov, Director of the Statistics and Reporting Department. 

At the meeting, the MPC members focused on projected inflation trends, risks of a longer and more significant than expected inflation surge globally and in Ukraine, and the likely scenarios for the NBU’s response.

The current inflationary developments are close to the trajectory projected in the NBU’s July macroeconomic forecast, the discussants pointed out. In September, consumer and core inflation accelerated as expected (to 11% yoy and 7.4% yoy, respectively). However, both figures were even slightly lower than anticipated. This was primarily due to a stronger hryvnia, which restrained the growth in prices for imported goods and goods made of imported inputs.

However, pro-inflation risks on the forecast horizon have increased, the discussants agreed. One of the key risks to inflation slowing to 5% in 2022 is significant external price pressure. Global inflation is fueled by the further growth in energy prices, shortages of raw materials and components amid robust aggregate demand, and disruptions in global supply chains because of the pandemic. As a result, inflationary pressures from Ukraine’s MTPs continue to rise. Anticipating a longer and greater increase in inflationary pressures, central banks in EMs have increasingly resorted to key policy rate hikes. Central banks in developed countries are also increasingly signaling readiness to roll back their monetary policy easing cycles.

Ukrainian companies are experiencing an increase in production costs as well. Against the backdrop of economic recovery and improving business expectations, businesses are also expecting a further increase in prices for their own products and services. This growth is primarily driven by the increase in purchase prices for raw materials and supplies, and labor costs. Faced with staff shortages as labor migration revives, companies are choosing to pay higher wages.

The increase in real incomes, wages especially, has underpinned sustained consumer demand. This is evidenced by the high pace of growth in retail trade, record car sales, and significant imports of food and consumer durables. The major purchases index continues to grow. At the same time, surveys show that the ability of businesses to use their capacities to meet the unexpected surge in demand has been declining for the fourth quarter running.

Inflationary expectations of all groups of respondents – households, businesses, and analysts – are slowly worsening amid high rates of inflation. A further deterioration of expectations poses a significant risk that inflation may not decelerate to its 5% target next year.

The new forecast includes higher-than-expected energy prices in the next few quarters, and higher wage growth. As a result, the discussants agreed that the new forecast must also contain a tightening of monetary conditionsto offset new pro-inflationary factors. 

Seven MPC members called for maintaining the key policy rate at 8.5% in October.

Current inflation developments are close to the July forecast, and the updated forecast takes into account the growing impact of pro-inflationary factors over the forecast horizon, but it is more relevant for the medium term, some of these MPC members said. As specified in the new forecast, the delay in the monetary policy easing cycle is an adequate response to the strengthening of pro-inflationary factors. Under the new forecast, inflation will peak in the fall, decline at the end of 2021, and slow further to 5% in 2022.

In the short term, inflation developments will likely be even better than expected, one participant in the discussion said. High crop yields will help slow inflation at the end of this year and early next year. Although prices for goods such as grain or sunflower oil are shaped by currently high global prices, prices for a significant number of other food products are primarily determined by domestic factors. As a result, the increase in their supply, driven by the good harvest, will have a positive effect on domestic price dynamics.

In addition, this year’s strengthening of the hryvnia has yet to be fully priced in by consumer goods, meaning the pass-through effect continues. Gradual key policy rate hikes in other countries will not have a negative effect on the performance of the exchange rate transmission channel. Most likely, this will only restrain the NBU’s ability to make FX purchases to replenish reserves, but it will not significantly affect underlying trends in the FX market. Meanwhile, the tightening of monetary policy by many central banks around the world will slow global inflation and its transfer to the prices of goods and services in Ukraine.

However, inflation risks in the medium term (primarily in H2 2022) have actually risen, in part due to the surge in energy prices and the recovery of Ukraine’s economy, this MPC member said. In such conditions, postponing the beginning of the NBU’s monetary policy easing cycle will be an adequate step to curb inflationary pressures and the right signal to the market, this MPC member said.

In particular, it could increase the effectiveness of the interest rate channel of monetary transmission, he noted. Banks expected the NBU to promptly return to the cycle of monetary policy easing next year and were in no hurry to revise their interest rate policies. However, the new forecast on keeping the key policy rate no lower than at 8.5% at least until Q3 2022 will signal a monetary policy tightening in the longer run.

Another discussant added that keeping the rate flat in October, being in line with  the forecast, would also meet the expectations of most analysts. The current inflationary pressure is quite effectively leveled through the exchange rate channel of monetary transmission, this MPC member said. With the NBU continuing to pursue a flexible exchange rate policy, the favorable FX dynamics will remain the main disinflationary factor.

At the same time, several MPC members were concerned about the slow transmission of previous key policy rate increases to bank interest rates. One of them pointed out that, on the retail deposits market, market makers had ample liquidity and generally were not going to raise interest rates in the near future. To this end, other banks which aim to increase their market share plan to raise their rates only slightly. In order to improve the transmission, one of the MPC members suggested to consider applying other monetary instruments at the following meeting. Several other participants of the discussion supported this idea.

Three MPC members called for hiking the key policy rate to 9.0% at the October meeting.

They believe that the current inflation trend being close to the trajectory of the previous forecast does not guarantee such proximity in the future and thus is not a sufficient reason to keep the rate unchanged. Pro-inflationary risks increased and prevail significantly over the forecast horizon. Therefore, the NBU should be proactive in order to retain trust in the monetary policy and prevent de-anchoring of expectations.

One of these MPC members emphasized the absence of relevant disinflation factors that could drive inflation down to the 5% target in 2022. Global inflation continues to rise, in particular due to further growth in global energy prices and the worldwide shortage of raw materials and components. Prices are increasing for the main goods of both Ukraine’s exports and imports. On the one hand, the large harvest and growth in food exports restrain inflation through the exchange rate channel. On the other hand, high global food prices also directly impact the production cost of food products on the domestic market. Energy prices will remain high for a long time, including due to Russia’s aggressive policy to make Europe buy natural gas from its Nord Stream 2 pipeline. In addition, the growth rate of the Producer Price Index is threatening. The business outlook survey confirms that companies are concerned about further growth in purchasing prices. All of this will later impact consumer inflation. The exchange rate channel remains the only disinflation factor, but alone it cannot neutralize all the pro-inflationary drivers.

The same discussion participant also drew attention to expectations of analysts: they forecast no changes in the key policy rate, but on the other hand they do not believe that inflation will slow to the target of 5% at the end of next year. This shows that the NBU’s position is perceived as passive, which may affect trust in the central bank and worsen inflation expectations.

Another participant of the discussion underlined that the deterioration in households’ and analysts’ expectations was already signaling the need for monetary policy tightening. The interest rate channel of monetary transmission will not be effective without the NBU taking more resolute actions. Liquidity being extremely high, banks will not be incentivized to raise their loan and deposit rates. More key policy rate hikes by the NBU and clear communication of further monetary policy tightening can encourage them to do so. Conversely, if the NBU takes a passive policy amid high inflation, households may rush to withdraw their savings from bank accounts to make consumer purchases and buy foreign currency. The realization of this scenario would worsen the inflation development and require a reactive, and thus stronger, monetary policy response.

Another MPC member noted that the so-called transitive nature of inflation started showing clear signs of a steady underlying pressure. Pro-inflationary factors are many, so even their partial materialization would lead to a substantial increase in the inflation trajectory. Moreover, a deterioration in inflation expectations in Ukraine and active phasing out of monetary stimuli in most countries speak for monetary policy tightening. Other central banks raising their key rates will reduce interest in hryvnia assets and weaken the effectiveness of the exchange rate channel of monetary transmission. This discussion participant believes keeping monetary policy loose is unreasonable under such conditions. In order to curb inflation, the key policy rate should exceed the neutral level, or at least approach it more rapidly.

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

Five members expect no changes in the key policy rate until the end of 2021. The other five believe that the NBU should be ready to raise the key policy rate at the December meeting and prepare market participants to this step, given the high probability that pro-inflation risks materialize. In particular, three MPC members expect the rate to be raised by 1 pp by the year end, while two members project a 0.5 pp increase.  Almost all MPC members expect the key policy rate at 7.5%–8% as of the end of next year. One discussant believes that it will be higher than today, at 9% in late 2022.

The decision to keep the key policy rate at 8.5% per annum was approved by the NBU Board at the monetary policy meeting held on 21 October 2021.