Dear colleagues,
I’d like to greet all the participants at our first meeting this year following the Board meeting on monetary issues.
I would like to inform you that the NBU Board has decided to raise its key policy rate to 16% per annum, effective 26 January 2018. The tighter monetary policy will help decrease the inflation and bring it back to the target range in the middle of 2019.
First, let us summarize the inflation development in 2017
Last year, headline inflation reached 13.7%, exceeding the target of 8% ± 2 pp set for the National Bank of Ukraine in the Monetary Policy Guidelines for 2017 and Medium Term.
Inflation sped from 12.4% in 2016, and its deviation from the target was mainly due to factors on which monetary policy tools have only a limited effect.
Comparing the inflation forecast of 9.1% made a year ago and its actual value as of the year-end, the difference makes 4.6 pp. Over a half of this deviation can be attributed to a rise in raw foods prices.
As we mentioned several times before, last year saw a noticeable decrease in the supply of some foods resulting from the unfavorable weather conditions seen in the first half of last year, the unstable situation in animal breeding, and a rise in the global prices of, and demand for, Ukrainian foods, mainly meat and dairy products. As a result, raw food prices rose 24% over the year pushing processed food prices up.
An increase in production costs, especially labor costs, also contributed to the growth of prices for goods and services. Consumer demand recovered at a fast pace, proven by a hike in retail turnover by 16% yoy in December.
Besides, the underlying inflationary pressure increased at the year-end, as evidenced by a rise in core inflation, to 9.5% in December and high inflation expectations.
First, the prices were affected by the foreign exchange market conditions in the last month of the year. Prices of Ukrainian export goods, in particular steel, iron ore and wheat generally remained favorable. At the same time, FX supply felt the impact of seasonal decrease in revenues from the agricultural sector, as well as significant hryvnia liquidity of exporters from received VAT refunds. Thus, this resulted in increased volatility of hryvnia exchange rate. The NBU alleviated these fluctuations by FX interventions. In December net FX sales comprised USD 183 million.
Second, December was noted for noticeable easing in fiscal policy in contrast to other months, thanks to, among other things, a sharp increase in pension payments and budgetary spending being unevenly distributed over the year. Moreover, the shift in the state budget spending to the end of the year was stronger than in the previous years.
As a consequence, the deviation of inflation rate was greater than the NBU anticipated in its October 2017 Inflation Report.
It should be noted that the NBU could have partly restrained the inflation growth by shifting earlier to the tight monetary policy.
In 2017, the monetary policy was rather tight, i.e. the real interest rate (with account for inflation expectations) ranged throughout the year from 5% to 7%. However, the policy was not tight enough to neutralize pro-inflation factors.
When will inflation reach the NBU targets?
Inflation will gradually decrease in 2018 through 2020. Inflation will gradually decrease in 2018 through 2020, mainly due to the central bank conducting a tight monetary policy over the forecast horizon. However, the NBU projects that inflation will remain high in 2018: headline inflation will be 8.9% and core inflation will be 8.2%. This inflationary pressure will be due to several factors, such as:
First, the rise in the prices of raw foods (mainly meat and milk) that occurred last year will be further passing through to the prices of highly processed foods.
Second, household income will continue to grow resulting from both higher social standards and a further increase in wages in the private sector amid high demand for labor. Therefore, growing consumer demand will also boost the prices.
Third, an increase in the external vulnerability of the economy, due to delayed cooperation with the IMF, makes it more difficult for Ukraine to attract capital, and consequently, puts pressure on the hryvnia exchange rate.
Moreover, inflation is affected by the high inflation expectations of households and businesses, resulting from consumer prices’ current pace of growth, and the FX market volatility seen in recent months.
Also, a hike in global oil prices, which pushes domestic prices up,.
In the future, the inflation decrease will be ensured by a tight monetary policy, a rise in supply of foods and a moderation of imported inflation.
Both raw food price growth and core inflation, which significantly depends on the former, will slow down.
As a result, the inflation will return to its target range in the middle of the year 2019 and will be 5.8% by the end of the following year. In 2020, inflation will decelerate to 5.0%, thus corresponding to the mean value of the target range (5.0% ± 1 pp).
We have also updated macroeconomic forecast for 2018-2020
We expect the economic growth to accelerate to 3.4% in 2018. Private consumption will be the main driver of the economic growth. This will be fostered by sustained high real wages growth rates, as well as other household incomes, including pensions. Besides, loosening the fiscal policy will be an additional contributor. Also, companies’ investment activity will stay robust.
Real GDP growth is expected to slow down to 2.9% in 2018-2020. This will result from wearing off this year’s fiscal easing effects and impact of the tight monetary policy necessary to bring the consumer inflation to the target level over the forecast horizon. Furthermore, a slow progression of the structural reforms will withhold the advancement of long-term economic prospects.
Over the forecast horizon, resumption of lending will be slow primarily due to high risks of the institutional environment, such as the low level of protection of creditors’ rights.
The role of exports in the economic growth will gradually strengthen complementary to favorable trade conditions and expanding access to foreign markets. The export increase will also sustain recovery of manufacturing in certain industries that lost supply of products manufactured by companies in non-government controlled area in the previous year. At the same time, boosted domestic consumption and investment demand will continue to drive imports. Thus, the current account deficit will maintain the level of about 3% of GDP in 2018–2020.
A key assumption of the macroeconomic forecast is that Ukraine will continue to cooperate with the International Monetary Fund. This will sustain access to official funding from other organizations, as well as access to international capital markets in the forecast horizon.
This year the NBU expects about USD 2 billion tranches from the IMF, as well as the EU and the World Bank loans to be issued to the government. The aforesaid will ensure an increase in international reserves up to USD 20.5 billion (covering 3.7 months of future imports) by the end of this year.
However, in the two following years, due to spiking reimbursement of the external public debt, the deficit of overall balance of payments and a drop in international reserves is expected.
A lack of the structural reform essential to maintain macrofinancial stability and continue cooperation with the IMF poses the main risk to the implementation of the mentioned scenario, according to the regulator.
The premature termination of the IMF program may impede Ukraine’s access to the international financial markets, which will bring higher currency depreciation and inflation expectations and raise probability of facing problems with external public debt servicing in the next years. In 2018-2020, the Government and the NBU have to pay more than USD 16 billion for external debt servicing. Hence, the NBU deems further cooperation with the IMF within the existing and new programs to be critical for maintaining macrofinancial stability.
Another considerable risk stems from a looser fiscal policy of the Government. In particular, faster growth in social spending than in labor productivity may aggravate the inflationary pressure. If this should be the case, the NBU will have to resort to creating tighter monetary conditions than in the baseline scenario.
Why did the regulator decide to hike the key police rate despite expecting downward trend in inflation?
Raising the key police rate will help bring inflation down to the target level and alleviate the pro-inflation pressure stemming from the outlined risks if they materialize.
The implementation of inflation targeting regime in Ukraine, particularly, two recent hikes of the key police rate in October and December last year, evidences that monetary policy acts effectively through the interest rate channel. That means influencing interest rates in the economy, particularly lending and deposit rates set by commercial banks.
For example, since the key policy rate hike in October, the Ukrainian Index of Interbank Rates rose on average by 1.7 pp, retail deposit rates were up by 0.5 pp, rates on corporate loans - up by 1.5 pp.
Higher rates based on today’s decision will encourage saving, with the effect of restraining consumer demand. Higher rates will make domestic currency financial instruments more attractive compared with similar foreign currency instruments, which will help decrease inflation in future through the exchange rate channel. In addition, tight monetary policy will prevent inflation expectations from further deterioration.
What kind of monetary policy is expected in the future?
The NBU will continue to focus on price growth deceleration and meeting the inflation targets.
I would like to stress that in the absence of indications of the lowering inflationary pressure the NBU may further increase the key policy rate to return inflation to its medium-term target. However, as before, the central bank will balance between the need to reduce inflation on the one hand and to minimize short-term consequences for economic growth and lending resumption on the other.
The NBU’s detailed macroeconomic forecast will be published in the Inflation Report on 1 February 2018.
The next meeting of the NBU Board on monetary policy issues will be held on 1 March 2018.
Thank you for your attention!