The National Bank of Ukraine (NBU), which has now raised its key policy rate by 13 percentage points since April 2014, also scrapped daily auctions of foreign exchange as part of its shift to a policy regime of inflation targeting.
"The main reason for this decision is that inflationary risks remain high in the near term, reflecting primarily significant uncertainty regarding further developments in eastern Ukraine," the NBU said.
At times Ukraine's hryvenia currency has been in freefall since early 2014 when the conflict with Russia broke out over the Crimean peninsula and eastern Ukraine.
Ukraine had been expected to raise its rates after NBU Governor Valariya Gontareva said on Jan. 16 that the bank was considering raising rates to combat inflation.
The hryvenia fell 48 percent against the U.S. dollar in 2014 and has continued to drop this year, trading at 16.78 to the dollar today, down 51 percent since the start of 2014 and 6.0 percent this year.
Ukraine's consumer price inflation accelerated to 24.9 percent in December from 21.8 percent in November while core inflation rose to 22.8 percent from 19.6 percent.
The central bank said the main reason for acceleration was the hryvenia's depreciation from deteriorating expectations linked to socio-policial events and the military conflict. An increase in administered prices from economic reforms also contributed to rising prices.
Ukraine's economy has also been hit hard by the conflict with Russia, but the central bank said rising interest rates will have minimal effect as bank lending is already limited to the high risks.
The central bank estimates that Gross Domestic Product contracted by 6.7 percent in 2014 and will fall by another 4-5 percent in 2015, with the negative output gap around 8-9 percent of potential.
The National Bank of Ukraine issued the following statement: (translation by Google)
"Board of the National Bank of Ukraine in preparation for the introduction of the regime of inflation targeting is taking appropriate decision to change the operational approach of monetary policy to improve its efficiency and transparency for market participants.
Decisions taken by complying with the recommendations of the Committee on Monetary Policy (hereinafter - the Committee) on the basis of analysis of the prospects for economic and monetary market.
The main changes are:
- enhancing efficiency in the discount rate as the base rate of the monetary policy. Interest rates on liquidity regulation instruments will be determined depending on the level of the discount rate;
- termination of from 5 February 2015 daily FX auctions rejection of the indicative rate. Hryvnia exchange rate banks on the basis of objective parameters of market supply and demand.
This will eliminate uncertainty, greater efficiency and objectivity pricing mechanism for credit and foreign currency in the interbank market and increase the efficiency of monetary instruments of the National Bank.
At the same time in order to ensure predictable and controlled development of the market situation, the National Bank will apply tighter monetary policy. Specifically decided to increase from February 6, 2015 the discount rate from 14.0% to 19.5% per annum and a corresponding adjustment to interest rates on active and passive transactions of the National Bank.
The main reason for this decision is that inflationary risks remain high in the near term, reflecting primarily significant uncertainty regarding further developments in eastern Ukraine. In December 2014, consumer inflation reached 24.9% yoy. Core inflation rose to 22.8% and particularly accelerated in the last three months. The main factor accelerating inflation were devaluation of hryvnia exchange rate as a result of accumulated imbalances in recent years and the deterioration of expectations due to socio-political events and military conflict in eastern Ukraine. A significant contribution to the growth of consumer inflation was also caused by the increase in administered prices and tariffs through the necessary economic reforms.
A tight monetary policy of the National Bank of Ukraine will stabilize the money market by increasing the attractiveness of financial instruments in local and demonstrate decisive National Bank of Ukraine to perform a priority goal of achieving and maintaining price stability in Ukraine.Increasing interest rates along with other stabilization measures of the Government and the National Bank of Ukraine under the new program with the International Monetary Fund will help slow the rate of inflation in the first half of 2015 and will provide the basis for the return of inflation to odnoznakovoho level in 2016. According to the National Bank of Ukraine level consumer inflation at the end of 2015 will be 17.2%.
At the same time, rising interest rates will have minimal effect on activity in the real economy, as lending banks is significantly limited because of high-risk business environment. The fall in GDP, the rate is estimated by experts at the National Bank of 6.7% in 2014 and 4 - 5% in 2015 is primarily due to structural and supply-side factors. Although negative GDP gap is quite substantial - 8 - 9% of potential GDP according to experts of the National Bank of Ukraine, actual convergence of GDP to its potential level in the medium term is possible only because of macro-financial stability, which will contribute and tighter monetary policy.
Risk analysis for the stability of the banking system as a result of higher interest rates showed that they are relatively low compared to the risk of further devaluation of the hryvnia. In addition, the general increase in interest rates in the banking system has become one of the factors restoration inflow of retail deposits with a corresponding decrease in inflationary pressures, which also contribute to the overall macro and stabilization in the country.
Along with increased rate of the National Bank of Ukraine plans to strengthen its role as the base rate of the monetary policy. In particular, interest rates on liquidity regulation instruments will be determined in close relation to the level of the discount rate. This solution will provide synchronization of all rates, which operates the National Bank. The operating system of monetary policy, the cornerstone of which is now the discount rate will be simpler and more transparent to market participants.
The discount rate is the base relative to other interest rates of the National Bank of Ukraine. The discount rate is the benchmark cost of borrowed funds - changing its size, the National Bank of Ukraine is a signal to market participants about the direction of monetary policy to perform its main function to ensure the stability of the hryvnia.
By this discount rate last changed November 12, 2014, when it was set at 14.0% per annum.
Committee established by the National Bank of Ukraine under transformation regulator to enhance institutional capacity, ordering the decision making process of monetary policy and strengthening communication with the public regarding the determinants of rishen.Diyalnist Committee aims to develop proposals for setting and changing accounting and other interest rates of the National Bank ; parameters of active and passive operations of the banking system liquidity regulation; definition and implementation of monetary and exchange rate policies; size and order of formation required reserves for banks; coordination of monetary and fiscal policy.
The next meeting of the Committee END detsya 2 5 February 2015. "