International experts have conventionally categorized the central banks of emerging market economies as “doves” and “hawks”. The “hawks” included central banks, which have raised key policy rate several times this year to counter rising prices. In contrast, the “doves” are banks who liked to implement a policy of supporting economic growth, even when prices increased rapidly. At present, our economic recovery will directly depend on which “flock” the National Bank of Ukraine will join.
Indeed, the average inflation rate in developing countries will reach 5.5% this year, and in Ukraine, according to the NBU’s projects, it will be even 9.6%.
Unprecedented monetary support, gradual recovery of consumer demand, disruption of global supply chains, and numerous deficits have contributed to rising world prices. However, IMF experts predict that the impact of these factors will be offset next year, leading to more sustained price pressures and returning the inflation rate to the level of 2019 in mid-2022.
In response to inflationary pressures, some emerging market central banks have begun to hike key policy rates: since March 2021, the central banks in Angola, Brazil, Chile, Colombia, Hungary, Mexico, Peru, Ukraine and Russia have done it. In September-October, the central banks of Poland, Romania and Azerbaijan joined to them.
International experts, many of whom recognize the short-term nature of the factors that cause inflation to accelerate, have not approved the aggressive policy of the central banks of emerging markets. In addition, they point to the following: most central banks in advanced countries do not even plan to fight inflation by raising the key policy rate this year; on the other hand, emerging market central banks have already been actively using this tool.
Fitch Rating analysts mention an interesting aspect: “Monetary policy in emerging market economies is changing very fast, despite the fact that some of the factors driving up inflation are temporary, for example rising food and energy prices, recovering demand after the opening of economies, supply bottlenecks and others; the GDP gap remains deeply negative in many of these countries, and the effect of the benchmark base will reduce the reported inflation rate at the end of the year, even if its monthly rate remains unchanged.
Thus, central banks in emerging markets have generally shown less tolerance for exceeding inflation targets than central banks in advanced economies, even though current inflationary pressures are recognized as temporary.
The problem of weak economic growth is more painful for Ukraine than for most emerging market economies, and therefore there are few excuses for the “hawk” monetary policy in our country. As the pandemic continues and the economic recovery is weak, the complete disregard of the central bank for economic growth can be considered as criminal negligence. Real GDP of Ukraine for the third quarter of 2021 grew by only 2.4% compared to the third quarter of the previous year, and according to the recent forecasts, Ukraine’s GDP is to go up by 3–3.5% in 2021. According to the IMF, the real GDP of advanced economies will grow by 5.2% in 2021, and the real GDP of developing countries and emerging market economies will increase by 6.4%.
In the latest Global Financial Stability Report, IMF staff point out that the abrupt tightening of monetary policy in some countries could undermine the economic growth. Therefore, they recommend that emerging market central banks walk a delicate line between supporting economic recovery and responding to inflation. According to IMF experts, central banks can let themselves ignore temporary inflationary factors and avoid tightening monetary policy if they have “anchored” inflationary expectations until they have a clear idea of the duration of price drivers. The IMF predicts that overall inflation will return to pre-pandemic levels in mid-2022 in both advanced economies and emerging market economies.
Another spillover effect of tighter monetary policy that should be taken into account is the rise in market interest rates in the domestic market, including government borrowing rates. International experts warn that rising interest rates could reach a level where debt service will cast creditors’ doubt about state solvency, and increased government credit risks will negatively affect foreign exchange market processes and pose threats to macro-financial stability.
In October 2021 report, the IMF emphasizes that in the absence of a strong recovery, tighter domestic financial market conditions will increase debt service costs and worsen debt sustainability for governments.
This problem is especially relevant for Ukraine, as the share of debt interest payments in state budget expenditures is already approaching 12%. The ratio of debt service payment to GDP in 2019-2020 was 3% of GDP, and in January-September 2021 – 3.3%. In emerging market economies, debt service payments in 2020-2021 are only 1.8% of GDP. In other words, among emerging markets, Ukraine has 1.8 times higher interest payments on public debt at a lower level of public debt, and further growth in market rates (as an attribute of tight monetary policy) will further exacerbate this problem.
Moreover, the structure of Ukraine’s public debt is vulnerable to exchange rates and debt refinancing risks. For instance, the gross needs for government financing in 2021 are estimated at 19.7% of GDP, which exceeds the threshold of 15% of GDP and the average level in emerging markets (13.6%). The high level of these risks indicates the possibility of debt complications in the case of a sharp devaluation of the hryvnia or loss of access to external financing. Therefore, the problem of debt risks should not disappear from the agenda, including while developing monetary policy.
According to IMF experts, a preemptive tightening of monetary policy can be justified only with the aim of preventing a possible unanchoring of inflation expectations. In addition, such decisions should be made taking into account a whole range of factors, including the evolution of the pandemic, the inflation and economic outlook, the risk of cross-border spillovers, the risks to macro-financial stability. On the other hand, the degree of public confidence in the central bank policy and its communication policy are of paramount importance for achieving this goal.
In Ukraine, a study by the NBU conducted jointly with GfK Ukraine and Info Sapiens shows that inflation expectations of three groups of respondents: financial analysts, banks and enterprises for the next 12 months do not exceed 8%. The NBU in its latest Inflation Report notes that the measures taken by the NBU, the favorable situation in the foreign exchange market and the fall of actual inflation in the future will contribute to a slow improvement in inflation expectations.
When designing monetary policy in Ukraine, consideration should also be given to the fact that national inflation more than in other countries is cost inflation. The continued reform of the energy sector and high dependence on energy imports have led to a manyfold increase in gas and electricity prices for Ukrainian business. The monetary response to non-monetary phenomena (not related to excessive aggregate demand) usually has unfortunate consequences in the real sector of the economy. With supply shocks dominating, the “hawk” monetary policy of the central bank, instead of preventing an inflationary spiral, will untwist the spiral of bankruptcies and unemployment. This will obviously trigger more significant problems for the national economy than a temporary rise in inflation.
Thus, given the anemic economic growth in Ukraine and debt sustainability risks, the National Bank should not blindly follow the canons of inflation targeting and move to a tight monetary policy. In addition, in our country there are no key prerequisites for the transition to a tight policy to combat inflation – the long-term nature of the factors triggering higher prices, and violation of the fixation of inflation expectations.
Meanwhile, some experts and officials in Ukraine are loudly calling for a tough response to the NBU’s interest rate policy to accelerate inflation. In particular, one of the members of the NBU Council believes that the current key policy rate of the NBU is in the stimulus zone and recommends the National Bank to increase policy rate in response to inflation and achieve “such combination of policy rate and reaction of exchange rate that will not leave doubt about playing up to oligarchic interests from the side of monetary policy”. The destructive nature of these proposals for the national economy and the prospects for macro-financial stability is beyond doubt.
We think that the National Bank of Ukraine should avoid a “hawk” reaction to the temporary acceleration of inflation with sharp changes in key policy rate. It should be noted that from March 5 to September 10, 2021, the key policy rate was already increased by 2.5 percentage points. Calls to increase it further are inappropriate, as even at a constant nominal rate in early 2022, its real rate will be + 1.8% per annum (taking into account the NBU inflation forecast for 2022 at 6.7%). In most countries, the key policy rate of central banks in real terms continues to be negative.
In our opinion, in December 2021 it is necessary to keep the key policy rate at the current level of 8.5% only to offset the current inflation surge with the prospect of further reduction of the rate in 2022. This policy will allow:
• supporting the economy during a pandemic and providing a positive impulse for post-crisis economic recovery;
• intensifying bank lending processes and reducing the impact of pro-inflationary factors on the supply side;
• preventing further increases in debt service expenditures and strengthening the debt sustainability, which is the key to long-term macro-financial stability;
• restraining inflation expectations and preventing the unwinding of the inflationary spiral, which also requires a prudent communication policy of the NBU, aimed at increasing public confidence in monetary policy and actions of the central bank.
Vitalii Lomakovych, Founder and Chairperson of the Board of the Growford Institute, and Tetiana Bogdan, Scientific Director of the Growford Institute, for Dzerkalo Tyzhnia.