Summary of the discussion of the NBU Monetary Policy Committee members on the key policy rate on June 12, 2024

Date of the meeting: June 12, 2024.

11 out of 11 members of the NBU's Monetary Policy Committee (MPC) were present.

The MPC members discussed the room for further easing of monetary conditions, given the subdued price dynamics, the continued improvement in inflation expectations, and the balance of risks to the future inflation trajectory

The discussion pointed out that consumer inflation has remained below the NBU's forecast and target range in recent months. Thus, after a long period of decline, inflation remained unchanged in April and accelerated only slightly in May, to 3.3% year-on-year. The weaker-than-forecast price dynamics was primarily due to temporary factors. However, the persistence of low inflation for a long time contributed to an overall improvement in inflation expectations, which proved resilient even to a certain weakening of the hryvnia. The improvement in inflation expectations offset pressure from further growth in business costs. Core inflation was in line with the NBU's forecast.

The situation on the foreign exchange market remained under control despite the hryvnia's depreciation, in particular as a result of increased budget spending. The NBU maintained an active presence in the FX market to compensate for the structural shortage of foreign currency and prevent excessive exchange rate fluctuations. Accordingly, the NBU's interventions increased in May.

Although there were some changes in the balance of risks to inflation and exchange rate stability on the monetary policy horizon, they were largely offsetting. On the one hand, there is a growing risk of additional budget expenditures to maintain defense capabilities in the face of a protracted war, which is likely to require a number of tax hikes and could affect inflation. On the other hand, Ukraine is managing to consolidate international support to counter Russian aggression. This is reflected both in the increased supply of weapons and in additional funding commitments by international partners. In particular, at the time of the MPC meeting, a decision on the use of Russia's immobilized assets was expected to be made following the G7 meeting, in addition to the decisions already taken in the US and EU.

Favorable inflationary dynamics, improved inflation expectations, and progress in obtaining international financing create room for further easing of monetary conditions to support a pickup in lending and economic recovery.

Nine MPC members supported a cut in the key policy rate to 13% in June.

In their view, such a measured step is the best solution at this time. It takes into account, on the one hand, the current favorable macrofinancial trends, and, on the other hand, the projected acceleration of inflation in the second half of the year, as well as the still significant risks posed by the effects of the war. In addition, this decision is consistent and expected by financial market participants. First, it is in line with the key policy rate trajectory included in the baseline scenario of the NBU's April macroeconomic forecast and forward guidance. Second, it is in line with the forecasts of financial analysts according to recent surveys. This step by the NBU is already built into expectations, so the reaction of financial markets to it will be restrained and predictable.

The panelists agreed that a cautious cut in the key policy rate would also be in line with the NBU's intention to protect households' hryvnia savings from inflationary depreciation. Despite the nominal decline in market rates, the real yields on hryvnia deposits and domestic government bonds remain positive amid improved expectations, and demand for these instruments remains strong. This is evidenced, in particular, by the continued positive dynamics of hryvnia time deposits, which outpaced the growth of households' foreign currency savings in banks. The high demand for domestic government bonds at the Ministry of Finance's auctions, including for long-term securities maturing in 2-3 years, is also indicative.

It is important to maintain interest in hryvnia assets in the future in order to limit pressure on the FX market and to cover the budget deficit from market sources. To do so, macrofinancial stability and sufficiently attractive interest rates in real terms must be maintained. One panelist called for taking into account that the effects of previous decisions to ease interest rate policy are still being realized, so it is necessary to continue to move gradually and weigh the potential effects of each step.

According to one of the panelists, the progress made in providing Ukraine with financing from immobilized Russian assets also supports the key policy rate cut. At the same time, another MPC member pointed out that there are still obstacles to using this source of funds. First, there is no final understanding of the modality of this funding, in particular, part of the promised money may be tied to Ukraine's implementation of certain reforms, which will affect the rhythm of such funding. Second, there is no final confirmation of the full amount of funding Ukraine needs for 2025 or in the event of an increase in the 2024 budget deficit to maintain its defense capabilities. Third, the world is entering a turbulent period of political elections, particularly in the United States and the EU. Their results may also affect the level of further support for Ukraine from international partners. A deterioration in the rhythm of international assistance and insufficient budget deficit financing remain risks that could make it difficult to maintain macrofinancial stability. Under these circumstances, the NBU's cautious steps are fully justified.

One panelist pointed out that core inflation is in line with the NBU's forecast. In his opinion, this indicates that consumer inflation is only temporary and below the target. Another panelist agreed, adding that the weakening of the hryvnia exchange rate in recent months has not yet been fully reflected in inflationary dynamics. It is likely that companies had previously built in a certain level of exchange rate into their prices with a margin, so they were able to partially absorb the rise in import prices through their own margins, which, among other things, kept inflation in check. However, in the future, we should expect that the carryover effects of the exchange rate depreciation will still be reflected in an acceleration of inflation. This is an additional argument in favor of a measured easing of interest rate policy, which is consistent with the NBU's intention to keep inflation at a moderate level this year.

Several MPC members agreed that while a significant number of pro-inflationary risks remain, some of them are likely to materialize as downside risks. In particular, an increase in electricity shortages as a result of Russian attacks on the power grid, on the one hand, leads to higher business costs, but on the other hand, it may lead to a reduction in consumer demand, which will accordingly curb inflation. A similar situation already occurred in late 2022 and early 2023, after the first massive Russian attacks on the Ukrainian energy system. Trends unfolding in the labor market as a result of mobilization processes can also have a multidirectional impact on inflation.

One MPC member spoke in favor of cutting the key policy rate to 12.5% in June.

According to this MPC member, the NBU could ease its interest rate policy more rapidly at this point in time to support economic recovery and stimulate growth in long-term hryvnia deposits.

This MPC member emphasized that inflation expectations remain well anchored, with actual inflation dynamics in May being better than forecast, and the increase in electricity tariffs largely taken into account in the April macroeconomic forecast. Even with the announced tax hikes, inflation is likely to only "catch up" with the forecast and rise to 8-9% this year. At the same time, the NBU should also take into account disinflationary factors that could significantly slow inflation over the monetary policy horizon. In particular, the deterioration in consumer and business expectations, which is observed against the backdrop of significant uncertainty about the duration of the war and the complication of the energy supply situation, is likely to have a restraining effect on prices. In addition, migration is likely to increase, depressing consumption and restraining inflation.

The task of making hryvnia savings attractive is now being accomplished. If the key policy rate is cut to 12.5%, it will continue to be significantly higher than both the current and expected inflation rates of all groups of respondents. Accordingly, the real yields on domestic government bonds and deposits will also remain positive, so these instruments will be in demand. In addition, banks' active competition for depositors, especially large ones, will keep market rates from falling.

Moreover, a more rapid decline in the key policy rate may encourage depositors to seek higher yields on long-term hryvnia instruments. Instead, the projected cut in the key policy rate - by only 0.5 pp - will not create such incentives, as it will rather signal the NBU's intention to continue to act in line with the forecast and complete the cycle of interest rate easing in 2024.

One MPC member favored keeping the key policy rate unchanged in June.

According to this participant, the NBU's interest rate policy should remain consistent and serve as an element of predictability. He recalled that in its previous statement of intent, the NBU had tied future key policy rate decisions to changes in the balance of risks to exchange rate stability and inflation. In his view, the balance of these risks has rather deteriorated in recent months. First, pressure on the foreign exchange market has increased, exchange rate expectations have deteriorated, and demand for cash has grown. Second, the implementation of tax hike initiatives seems highly likely and, together with an increase in utility tariffs, could have a significant contribution to inflation.

The inflation trend reversal already took place in May, and price pressures will continue to increase until the second quarter of 2025, according to the current forecast. Given the additional potential impact on inflation from higher indirect taxes and excise duties, this may negatively affect inflation expectations, which are adaptive and usually respond to price increases after the fact. As a result, the attractiveness of hryvnia instruments may be jeopardized at some point.

In turn, this could lead to a shift in depositors' preferences to foreign currency savings, which would increase pressure on international reserves, the hryvnia exchange rate, and consumer prices. In addition, a decline in the hryvnia's attractiveness will undermine progress in building a culture of long-term savings among households and in getting banks to work with longer-term financial instruments. Thus, the issue of maintaining the attractiveness of hryvnia instruments remains relevant. Accordingly, the NBU should pause in cutting the key policy rate so that it does not have to reverse its monetary policy later. Moreover, the transmission from previous decisions to ease interest rate policy is still ongoing.

The MPC members also discussed possible changes to the parameters of the operational design of the interest rate policy.

The panelists noted the important role that three-month certificates of deposit (CDs) played in making hryvnia savings attractive in 2023 and the first half of 2024. This instrument helped to create strong incentives for banks to compete for depositors and to create a steady upward trend in household demand for hryvnia time deposits and government bonds.

The three-month DS will continue to be part of the mechanism by which the NBU determines monetary conditions, influences the dynamics of market rates, and thus the attractiveness of hryvnia instruments. Accordingly, the MPC members agreed that by changing the design of this instrument, in particular by further reducing the spread between the key policy rate and the three-month DS rate, the NBU could further ease its interest rate policy. At the same time, opinions were divided on whether it was appropriate and whether there were appropriate macroeconomic preconditions for continuing to move in this direction.

Given the favorable macroeconomic trends, some participants in the discussion suggested that the spread between the key policy rate and three-month DS should be reduced at the current meeting. The majority of them supported a 0.25 pp reduction in the spread, in addition to a cut in the key policy rate. One participant called for a more substantial reduction in the spread, by 1.5-2 pp at once, noting that he believed such a move would not threaten the attractiveness of hryvnia savings.

At the same time, other MPC members urged not to rush into this decision until the macroeconomic forecast is updated and the balance of risks to inflation and FX market stability is reassessed more thoroughly. This will help determine whether there is room for additional monetary easing. In addition, the panelists noted that the impact of previous decisions to optimize operational design has not yet been exhausted. Banks, in particular market makers, continue to revise rates on hryvnia time deposits. More observations are needed to comprehensively assess the effects of the previous steps and to forecast the possible effects of further interest rate spread narrowing.

The MPC members agreed to continue discussing how to further optimize the operational design of the key policy at their July meeting. Most of the participants in the discussion supported a gradual process in order to avoid an excessive easing of monetary conditions and to maintain the attractiveness of hryvnia instruments.

The MPC members' opinions on the room for further key policy rate cuts were divided

Seven MPC members believe that there is still room for a key policy rate cut. In their view, the risks to the inflation forecast are well balanced. There are also reasons to expect sufficient external financing for both this year and next year. Given this, they believe that the NBU will be able to cut the key policy rate to at least 12-12.5% by the end of this year.

In contrast, four panelists believe that the potential for lowering the key policy rate this year has been almost exhausted. In their view, the balance of risks to inflationary dynamics is somewhat tilted upward, particularly given the large budgetary needs, the expected carryover effects of the hryvnia depreciation, and the likely deterioration in expectations due to the acceleration of inflation. These MPC members believe that it is highly likely that the key policy rate will remain at 13% at least until the end of the year.

At the same time, all the participants agreed that given the high level of uncertainty, the NBU should be prepared to continue to adapt its monetary policy flexibly in the event that the balance of risks to inflation and the FX market changes. When updating its July macroeconomic forecast, the NBU will be able to better assess changes in the balance of risks and the prospects for further macroeconomic development, and will base its decision on a new, more complete information picture and more detailed calculations.