Inflation is low, but loans are still unavailable. Why is this so?

The interest rate policy of the NBU depends on the accuracy of inflation forecasts, which directly affects the economy, starting with the availability of credit and ending with the level of the national debt. Overestimated inflation forecasts, which lead to the fact that the excessive interest policy becomes more rigid, are additional losses of the real sector and public finances.

What do we have? According to the latest data from the State Standards Institute of Ukraine (SSIU), actual inflation fell to 3.2% in March of this year, and the National Bank of Ukraine (NBU)  forecast calculations predicted that at the beginning of 2024, inflation would be 16.1%. Inflation forecasts of the NBU for 2023–2024 turned out to be extremely inaccurate: the forecast error is almost 400% of the actual inflation rate.

Moreover, the accuracy of the NBU's forecasts and the level of adjustment of its own forecasts deteriorate with each quarter. In January 2023, the NBU adjusted its inflation forecast for 2023 by 10%. In April - by another 21%, in July - by 28%, in October - by as much as 45%. The average correction of previously developed inflation forecasts for 2023 was 25% per quarter.

The consequences of incorrect inflation forecasts of the NBU are as follows:

• making suboptimal decisions on interest rate policy that do not correspond to the country's economic condition;
• expansion of the state budget deficit;
• increase in the need for international assistance;
• the need to apply additional tools to correct imbalances caused by erroneous monetary policy decisions (example - tax on excess profits of banks);
• decrease in confidence in the central bank.

The direct consequence of false inflation forecasts was the adoption of suboptimal decisions on interest rate policy. The NBU's inflation forecast is a key reference point for setting the discount rate on the monetary policy horizon.

If the actual inflation does not correspond to its expected trend, it means that economic subjects do not receive the expected "inflationary" increase in income, so the interest rate policy becomes more rigid than it was originally planned. It also narrows the scope for monetary policy in the event that tighter monetary parameters have to be applied in the future to suppress inflation.

As a result of inadequately high interest rates and war risks, the level of bank lending to the economy began to progressively decrease. Even large-scale government programs to support lending could not stop the reduction in the level of lending, which fell from 20 to 15% of the Gross domestic product (GDP)in 2023. The narrowing of the credit loan market is particularly painful for Ukrainian businesses, as there are no other alternatives for attracting additional funds (such as the stock market, venture financing) in Ukraine.

Errors in inflation forecasts led to the expansion of the state budget deficit. The National Bank of Ukraine's expenses on deposit certificates directly depend on the level of the NBU's discount rate, and the interest expenses of the Cabinet of Ministers of Ukraine on the Bonds of domestic state loans of Ukraine are elastically dependent (BDSLU). Lower-than-expected inflation forecasts mean that the government received lower-than-expected nominal tax revenue. And since the interest rates of public borrowings were elastically tied to the almost unchanged key rate of the National Bank of Ukraine (NBU), this led to an increase in the financial imbalance between the tax revenues received by the government and the interest expenses paid by the government, that is, to the expansion of the fiscal deficit.

Errors in inflation forecasts have led to increased needs for international aid. Since 50% of government expenditures are covered by international aid, we got a situation where, due to errors in the inflation forecast, foreign aid funds began to be redistributed to a much greater extent to interest payments on the Bonds of domestic state loans of Ukraine are elastically dependent (BDSLU), and from there (through the instrument of deposit certificates of the National Bank of Ukraine (NBU) to bank profits, than otherwise inflation forecasts were accurate. And the greater is the deviation of the key rate from inflation, the greater is the additional redistribution of international aid in favor of commercial banks.

Forecasting errors reduce the level of confidence in the central bank. This harms the management of expectations of economic agents and worsens the quality of monetary transmission in the system of monetary inflation control measures applied by the  National Bank of Ukraine (NBU).

 

Why the NBU made a mistake in assessing inflationary trends

The reasons for the unsatisfactory accuracy of the forecasts lie in the imperfect methods and models of the central bank, as well as in false assumptions. It is clear that in the conditions of war there are specific features and conditions different from the conditions of peacetime. However, when developing its forecast from mid-2022, the National Bank of Ukraine (NBU) neglected the influence of such factors as:

• the non-monetary nature of inflation, which was generated exclusively by factors of cost growth, and not by factors of demand;
• a drastic reduction in aggregate demand (real GDP fell by 25% relative to the pre-war period), which created the main downward pressure on prices;
• uncertainty with the terms of the end of the war. In its initial assumptions, the National Bank of Ukraine (NBU) assumed that the war would end at the end of 2022. In subsequent communications, the NBU constantly pushed back the deadlines for the end of the war (it is clear that this is not a matter of competence of the NBU);
• the impact of blocking export routes on the price level of agricultural raw materials in the domestic market.

Low demand was caused by martial law, high unemployment (about 20% of the workforce) and a large number of refugees abroad (about 6 million people). These factors were underestimated by the National Bank of Ukraine. The National Bank of Ukraine (NBU)  also underestimated the effects of the stabilization effect on prices from the exchange rate fixation and the government's moratorium on utility tariffs.

The sharp fall in inflation led to a rise in real interest rates, causing additional losses to business and public finances. Therefore, the causes of errors in the NBU's inflation forecasts must be clearly identified.

Until November 2021, the NBU Council was engaged in assessing the adequacy of the methods and forms of forecasting indicators of the economic and social development of Ukraine used by the National Bank. However, after amendments were made to the Law of Ukraine "On the National Bank of Ukraine" (as of November 10, 2021), this issue was excluded from the competence of the NBU Council. Thus, at the moment, the process of macroeconomic forecasting of the National Bank of Ukraine (NBU) is uncontrolled by society.

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It is noteworthy that in the global practice of state regulation, mistakes by central banks in inflation forecasts by monetary regulators are the subject of a harsh response from society. Thus, during 2022-2023, in Australia by decision of the government and in Great Britain by decision of the parliament, separate audits of the decision-making systems of the central banks of these countries were initiated, because they also made significant mistakes in forecasting inflation. At the end of 2023, changes to the legislation of Australia were already prepared, and for 2024, changes to the legislation of England are being prepared to reform the management systems of central banks and strengthen their accountability to parliaments. The trend to strengthen the control of central banks is gaining momentum in global practice.

Instead, in Ukraine, instead of checking the quality of work of the National Bank of Ukraine (NBU), on the contrary, the system of control over its activities was weakened. For more than a year, the supervisory body of the central bank, the Council of the NBU, has been functioning without a chairman and with only 66% of its members. Moreover, at the end of 2023, the Board of the National Bank of Ukraine (NBU)  liquidated the analytical division of the Council. Now all matters of organization of the work of the NBU Board and control - the NBU Council are in the office of the Board.

 

What is the role of the NBU policy in the slow pace of economic recovery

What is the National Bank of Ukraine (NBU) doing to strengthen the competitiveness of Ukrainian manufacturers and solve the fundamental problem of stability of the balance of payments? What losses did the country's financial system suffer after the introduction of the flexible exchange rate regime? How much did the state budget deficit expand as a result of the NBU's erroneous inflation forecasts? How much did market bank loans to businesses actually decrease due to the policy of high real positive interest rates? Society needs answers to these and other questions. However, representatives of the NBU pretend that they are not involved in the mentioned problems.

Moreover, the National Bank of Ukraine (NBU)  plans to tighten its monetary policy. Thus, in the parameters of the Memorandum with the International Monetary Fund (IMF), it is already possible to introduce certificates of deposit with a longer term, which will make it difficult for economic entities to find free liquidity. From November 2023, the National Bank of Ukraine (NBU)  switched to a monetary design based on the "lower limit" principle, which in the classic version provides for the establishment of payments to banks not only based on deposit certificates, but also based on required reserves, which will reduce banks' appetites for credit risks.

Read this article in Ukrainian and russian.