Why Do Prices Not Obey the NBU?

In September, the annual inflation rate increased to 8.6% compared to 7.5% in August. Annual inflation has already exceeded the forecast figures for 2024 expected by the government and the National Bank — 7.9% and 8.5%, respectively.

The first thing to pay attention to is the colossal variation in the values ​​of price growth when considering individual groups of goods and services: from minus 20.4% for egg prices to plus 63.6% for electricity prices. The range of values ​​is more than 80 percentage points!

Relatively high price increases (over 10%) were recorded for electricity, butter, bread, milk, cheese, fruits, vegetables, medical services and medicines, education services, food services and accommodation.

Instead, a decrease in the price level was recorded for eggs, meat, oil, sugar, clothes and shoes, household appliances, and recreation services.

What does this say? First of all, about the fact that in the current circumstances obey the key policy rate of the National Bank of Ukraine (NBU) has no influence on the fundamental trends of inflation. The amplitude of the values ​​of annual price increases for individual components of the consumer basket is six times higher than the level of the accounting rate. Variation in price increases is mainly determined by factors of cost growth, not by changes in the value of money in the economy or changes in general demand. Otherwise, the increase in prices would be more or less uniform. In some industries, the increase in the cost of expenses had a greater impact on the cost price, in others, the increase in the cost of expenses had a smaller effect, which ultimately led to various corrections of the final sales prices. The increase in the cost of energy carriers, the devaluation of the hryvnia, the war-related complications of logistics routes, the destruction of production facilities — all this affects the cost structure of different categories of manufacturers or suppliers in different ways.

Here it is important to remember that when inflation is generated by an increase in the cost of expenses (and not by an increase in demand), then its transfer to sales prices is inevitable, no matter how high the key interest rate of the National Bank of Ukraine (NBU) is. Market producers simply do not work below the threshold of profitability, because the business either goes bankrupt (opening the way for imports), or raises prices and tries to find its niche in the market.

The second factor that should be paid attention to when analyzing inflation is the dynamics of hryvnia exchange rate changes. The share of imported goods exceeds 50% in the structure of the population's consumer basket. During the year, the devaluation of the hryvnia amounted to 13% and continues to increase, despite significant currency interventions by the National Bank of Ukraine (NBU).

This indicates the preservation of increased inflationary pressure on the part of imported goods, and also indicates the ineffectiveness of the key policy rate and, in general, the policy of attracting hryvnia assets in curbing currency demand.

Unfortunately, the National Bank of Ukraine (NBU) was unable to stop the accelerated growth of currency demand. In January-September, the National Bank of Ukraine (NBU) spent USD 23.4 billion (+21% compared to 2023) to support the hryvnia. During 2024, the average daily currency interventions of the National Bank of Ukraine (NBU) doubled — from USD 70-80 million per day at the beginning of the year up to USD 153 million per day in September. The main influence on the increase in foreign exchange demand is exerted by the population, which in nine months of the current year bought USD 8.2 billion of cash and non-cash foreign currency, which is three times higher than the amount of the corresponding period last year.

The reason for the increase in currency demand is clearly the haste of the currency liberalization policy. In addition, the reason for this is that the introduction of a flexible exchange rate regime and the cancellation of a number of currency restrictions have unbalanced currency expectations.

A third factor to consider in the analysis of inflation is the impact of non-market war factors on changes in the structure of demand and the cost of expenditure. Military factors influence changes in priorities in consumer attitudes. In this way, non-essential goods began to be in lower demand. That is why we see a drop in prices for light industrial goods, household appliances, and entertainment services. On the other hand, military factors make adjustments in logistics and commodity markets, which affects the cost of producers.

Since military factors are non-market in nature, their effect cannot be reduced by the monetary instrument of the key rate of the National Bank of Ukraine (NBU), whose effect is market in nature.

The fourth key factor in inflationary dynamics is the hryvnia monetary financing of the NBU to finance government expenditures at the expense of foreign aid funds. The colossal fiscal deficit, which now reaches 23% of gross domestic product (GDP) for the current year (excluding grants), forces the National Bank of Ukraine (NBU) to carry out permanent hryvnia monetary financing. Only in 2024, the volume of additional hryvnia bills printed by the National Bank of Ukraine (NBU) and released into circulation through fiscal channels will amount to almost UAH 800 billion. And just since the beginning of the war, the hryvnia monetary financing of the National Bank of Ukraine (NBU) already exceeds UAH 3.5 trillion (including UAH 0.4 billion for the repayment of domestic government bonds). All this mass of hryvnia should theoretically exert enormous pressure on the domestic consumer and currency market. However, this does not happen. At least the impact of the fiscal deficit on domestic price growth is limited, as its size is only two-thirds of the loss of nominal gross domestic product (GDP) compared to the pre-war period. Also, "fiscal inflation" is restrained by the risks of military uncertainty, as a result of which the population is more willing to save the funds received from the state for the future than to spend on current needs.

The key policy rate at this moment is not able to significantly affect the fiscal component of inflation, since the size of public expenditures is dictated by military needs, and not by the availability of domestic loan funds.

Thus, the vast majority of factors that contribute to inflation in Ukraine are due to the increase in the cost of expenses. The dominance of non-monetary factors of inflation reduces the effectiveness of monetary instruments for combating inflation. The increase in the cost of expenses pushes prices up, regardless of the size of the key interest rate of the National Bank of Ukraine (NBU).

On the other hand, the monetary policy of the National Bank of Ukraine (NBU) is not able to significantly influence the price correction of market producers, since business in Ukraine does not rely on the leverage of banks but is mainly financed with its own funds. Business loans account for only 11% of gross domestic product (GDP).

However, the National Bank of Ukraine (NBU) continues to maintain ultra-tough interest rate policy parameters that have been in place for over two years. In September, the National Bank of Ukraine (NBU) key policy rate was 13% per annum, which in real terms (minus inflation) is 4.4%.

It should be taken into account that from the end of 2023, the National Bank of Ukraine (NBU) switched to the monetary design of the lower limit, and the key policy rate began to reflect not the average, but the lowest level of interest rates of the National Bank of Ukraine (NBU). If we calculate the average arithmetic rate of the National Bank of Ukraine (NBU) (for overnight deposits, term deposit certificates and refinancing loans), it was 14.8% per annum at the end of September, which in real terms corresponds to 6.2% per annum.

In conditions where the base rate of loan interest is several times higher than the rate of real gross domestic product (GDP), we should not expect an active recovery of economic activity at the expense of credit sources. Preservation of the conditions of real positive interest rates undermines the possibility of development of the real sector through the credit channel but has a very limited effect on inflationary dynamics due to the ineffectiveness of monetary transmission channels.

The inaccuracy of the monetary regulator's inflation forecasts is a separate aspect of Ukraine's inflation issues, because the inflation forecasts of the National Bank of Ukraine (NBU) are included in the prospectuses for changes in the key policy rate. The low quality of inflation forecasts and the underestimation of inflation factors may call into question the entire adequacy of monetary policy.

In 2023, the errors of the inflation forecasts of the National Bank of Ukraine (NBU) reached hundreds of percent, which led to an inadequate tightening of monetary conditions in the economy. In 2024, despite additional factors that contribute to inflation from the power generation deficit and a two-fold increase in electricity tariffs, the overall inflation rate (8.6%) remains lower than the forecasts of the National Bank of Ukraine (NBU) published last October, during the drafting of the state budget for 2024 (9.8%).

The permanent inaccuracy of the inflation forecasts of the National Bank of Ukraine (NBU) indicates the presence of systemic gaps in the preparation of the central bank's economic forecasts. The apparatus of the National Bank of Ukraine (NBU), which is involved in making models, needs adaptation to new economic conditions, in particular in terms of developing structural inflation forecasting models.

Regarding the difference in inflation forecasts for 2025. The government's macroeconomic forecast predicts annual inflation next year at 9.5%, while the forecast of the National Bank of Ukraine (NBU) predicts 6.6%.

I will say right away: there is nothing special about the difference between government and national bank forecasts. The Cabinet of Ministers of Ukraine and the National Bank of Ukraine (NBU) have different mandates and goals. The main task of the government forecast is its use during the preparation of the budget and other planning documents. Government forecasting is based on rational assumptions about the state of the economy and is therefore generally conservative. While the central bank's forecast has a targeted nature, namely it reflects its vision of the path to achieving inflation goals and is based on models that establish cause-and-effect relationships between monetary instruments and inflation.

Further inflation prospects will be determined mainly by factors that contribute to inflation. The devaluation of the hryvnia, the increase in electricity tariffs, a significant fiscal deficit, and the transfer of producer price increases to consumer market prices indicate a high probability of maintaining the trend towards higher inflation in the near future.