Disclaimer: The views expressed in this article are those of the author and do not necessarily represent those of the National Bank of Ukraine.
In a world dominated by headlines of ever-increasing inflation and relentless calls to action, central banks in both developing and developed economies balance both national priorities but also international forces in considering when and how strongly to react. A too large rate increase may disturb the vulnerable, highly leverage housing market, as is the case in several developed economies. Tackle now inflation but risk triggering financial stability concerns later. It may also choke the activity of young, feeble firms recently established on the economic ruins of the post-Covid period. A too late increase might strategically devalue the local currency if one’s main trade partner acts earlier. But what is clear, regardless of timing and size of increase, all dictated by the nature of the shocks (cost-push or demand-pull), the considerations of Inflation Targeting central banks are when and how to act.
In this world of painful tradeoffs, where errors are measured in terms of months too early or basis points too much, the NBU has baldly gone where no one has gone before (or at least, no one had expected). An increase in the key reference rate from 10% to 25% in one sitting is an absolute policy first, no doubt. But an inflation targeting independent central bank needs to act to fulfill its price-stability mandate. This dry and somewhat pedantic statement is the bridge taking us from 10% to 25%.
The post-covid recovery, with its supply-chain disruptions, Evergrande canal chocks and timid energy price increases, had already pushed inflation off course before the war. The NBU had therefore increased rates from 6% in January 2021 to 10% in January 2022. In late 2021, many economic actors and commentators were expecting further rate increases in 2022 to tame off the strong inflation whip from 2021. The NBU acknowledged the increases in inflation but assessed them as temporary. A prudent strategy was to wait and learn if the energy and supply chain shocks would persist. In any case, the cumulative 4% increase in one year (from 6% to 10%) is a substantial 67% increase compared to the starting point in January 2021. Even without the war, the expectations were that the NBU would have gone to 11% or more.
The February russian invasion has destroyed lives and livelihoods. In cold accounting terms, it has wiped out large parts of our capital stock (both private and public), dramatically increased uncertainty for both local and international economic actors (“Who would invest in agricultural equipment if it might be confiscated”) damaging long-term FDI and local investment, and through the massive emigration, further penalized productivity of human capital.
The intricate network of skills needed to produce for example a piece of software, has been ripped apart, with people displaced, unable to work or worse. The ongoing military push in the southern part of Ukraine hinders current exports, but also threatens a larger loss, that of access to the sea. Ukraine’s export strategy of “Brains and Grains” is under tremendous stress. The associated foreign exchange income is dwindling, subjecting central bank reserves to additional pressure. Households also act, swapping hryvnia for euros and dollars.
The new reality is that of many commercial activities moving in the shadow, transacting in foreign currency. The painful gains of de-dollarizing deposits, payments, and savings since 2015 had been all but canceled by the expectation that at some point, the NBU might no longer have the reserves to intervene in the FX market (recall our “Brains and Grains” export strategy) triggering a large devaluation and sudden jump in inflation. The already incomplete monetary policy transmission mechanism (in short, the set of activities and processes which transmit NBU’s changes in key rates in the economy) risks becoming a text-book fable. Once economic activity started to normalize, the central bank had to act. The exceptionally complicated context produced an exceptional action.
A highly uncertain data environment, with many official statistics missing, requires utmost caution. What if actual inflation is larger than what is being measured? Or economic activity, not properly surveyed, is stronger than reported? These immediate considerations, along with the medium-term threat of completely losing any efficacy of monetary policy provide context to the decision.
Some argue the move may be abrupt. It’s a moment of clarity on data and context and it is aligned with the very dull but essential guiding principle of Inflation Targeting central banks – react to current and expected inflation deviations from target. It was the first move since the war broke out and estimated inflation strongly moved in the two-digits territory. The NBU increased rates in line with prior pledges and to avoid the risk of signaling the abandonment of inflation targeting. In the April 15th Council Monetary Policy Guidelines, these risks are highlighted along with the “commitment to resume the pursuit of its inflation targeting regime with a floating exchange rate as the Ukrainian economy and financial system return to their normal mode of operation”. Given the force-majeure involvement in financing the war efforts, the loss of credibility resulting from abandoning price stability could have become the “straw that broke the camels back”.
On a back of the envelope calculation, tackling the post-covid inflationary flares showed that a roughly 70% increase in the key rate (from 6% to 10%) was absorbed by the market and slowed the rate of change in inflation. But that was a mild virus compared to what followed. A full-scale invasion with hundreds of billions of capital losses and millions of citizens displaced might be enough reason to consider a 100% increase of the interest rate, plus a margin of error for incomplete statistics. It’s only that now it all occurred at once, rather than over the course of 3 months. And it’s not only to tackle inflation, but also signal pre-war commitments are not abandoned in an exceptionally complicated environment.
Earlier increases would have been incompatible with the harsh constraints imposed by the war situation. For example, many reporting activities from commercial banks were delayed or outright suspended, many surveys of business and households postponed. Any earlier rate increases would have been done with the NBU having little or no ability to track its effects in the economy. Policy will have to focus on making sure we don’t slide back in the highly dollarized, little-to-no monetary policy effectiveness of the post 2015 years.
Not moving to tackle expected inflation would severely discredit the commitment of the NBU to inflation targeting, the fundamental price-stability principle underlining the NBU policy toolkit. In the same toolkit one also finds financial stability policies, these being the same policies which guided the NBU in its internationally acknowledged reaction once the war broke out. This is the commitment which is NBU’s hard currency when engaging international partners for financial assistance and local economic agents conducting their activities via hryvnia-denominated assets. Which at some point will turn into national and international investment sources, looking for clarity in terms of medium-term monetary policy priorities.
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