On 24 May 2018, the Board of directors of the National Bank of Ukraine decided not to change the interest rate, leaving it at 17%. The tight monetary policy is caused by a high fundamental inflationary pressure
The fact that the annual base inflation in April remained unchanged at 9.4%, whereas consumer inflation as a whole remained almost unchanged and reached 13.1% in annual terms.
According to the estimates by the National Bank of Ukraine, the unaltered interest rate at the aforementioned level causes rather tight monetary conditions for slower inflation and for reaching the target level in the medium term, taking into account the current inflationary risks. Here are some of the inflationary risks that are worth pointing out.
Increased consumer demand and production costs
The higher household income caused by improved social standards is currently the primary driver for the growth in consumer demand. According to the forecasts by the National Bank, the economic growth may reach its potential level as soon as the second quarter of the present year. Favorable trade terms, accelerated consumer and investment demand are expected to create a positive gap in the GDP until the end of the year. This reveals excessive consumer demand, which is likely to create pressure on prices.
On the other hand, the improved social standards generate supply inflation, as it causes an increase in production costs, for example, labor costs. As a result, producers are forced to increase the price of their product or service. This is why not only the goods and services that are included in the consumer price index are expected to become more expensive, but also those that are administratively regulated. For instance, the increase in the price on the latter category is likely to stimulate a further rise in excise duties on alcohol and tobacco products, prices of passenger and freight transportation, as well as that of energy resources.
Seasonal: worsening of inflationary expectations
If inflation is traditionally expected to slow down during the summer amid the increased supply of domestic vegetables and fruit, then the autumn-winter period, conversely, is characterized by the worsening of exchange rate expectations, which is a contributing factor to the accelerated inflation. At the same time, a seasonal drop in trade revenue denominated in foreign currency is associated with such periods. This is accompanied by increased demand for foreign currency, along with further pressure on the hryvnia and an accelerated consumer inflation.
Increased supply of hryvnia at year's end due to higher budget spending
Traditionally, at the end of the year budgetary spending tends to go up, which obviously boosts the supply of hryvnia. For example, in December of last year the amount of money left on the single treasury account dropped almost UAH 50 billion. Part of the hryvnia liquidity is transferred to the currency segment of the money-credit market. This stimulates additional demand for foreign currency, which causes a pressure on the hryvnia and remains in place at year’s end and at year’s start. The effect of currency devaluation in regards to exchange rate is transferred to consumer prices in the upcoming months.
The electoral process
The impact of inflationary risks may be reinforced by the ongoing electoral process in the country, which is traditionally accompanied by the worsening of exchange rate expectations greater fluctuations of the hryvnia exchange rate. Such effects may be significant in the case of a softer fiscal policy.
On the international arena, the risk of a trade war has become more apparent. Such a trade war could potentially cause a slowdown in the global economic growth. The impact of this risk may grow given the likely strengthening of the dollar due to tighter monetary conditions. The reason for a tighter monetary policy in the United States lies in the base inflation nearing the target level, as well as a fall in unemployment, although the effect of the increased spending and the recent tax cut has not been fully realized in the inflation figure yet. The strengthening of the dollar traditionally results in the volume of trade between the countries, which is more significant in developing nations.
The slowdown in global economic growth may potentially cause a drop in the demand for Ukrainian goods, followed by a decline in foreign currency-denominated revenue, which would put additional pressure on the Ukrainian national currency. Apart from that, higher prices on energy resources and food products may turn out to be the external factors of inflation in Ukraine.
Taking into account the high fundamental inflationary pressure and the current inflationary risks, the National Bank of Ukraine is conducting a tight monetary policy, the impact of which is not fully realized yet due to a time lag. The tight monetary policy is going to restrain the acceleration of inflationary pressure in the future.
At the moment, there are risks of slower introduction of structural reforms that may delay the acquisition of funds from Ukraine's international creditors, particularly from the IMF, as well as it may increase inflationary risks. Given these terms, the National Bank of Ukraine will be forced to raise the interest rate in order to secure tighter monetary conditions, which would allow inflation to decline.
Taking into account the significant inflationary risks and the likelihood of their coincidence in timing, the evaluation of the cumulative impact of such risks coming to fruition, as well as the interdependence between the price dynamics and different components of the consumer basket. Looking at it retrospectively, the cumulative effect on consumer inflation may be a lot greater than expected. That would lead to a correction of the monetary policy.
It is necessary to account for those threats to economic growth that emerge as the result of a tight monetary policy by the National Bank of Ukraine. In particular, the rise in the interest rate in January and March transformed into a growth in prices charged by producers in April suggest a gradual weakening of this impact, which could create certain prerequisites for economic growth in the future.
Nevertheless, the industrial output indices in the period between February and April fluctuated within a narrow range, with no apparent sustainable tendency for growth. The agricultural goods index in the current year is on the downhill trend (which impacts the consumer inflation negatively). A correction of the monetary policy towards tightening (which appears reasonable) may restrain the pace of economic growth.
In order to effectively neutralize the aforementioned risks it is necessary to improve the coordination between the monetary and the budgetary policy.