What happened to the NBU’s detailed forecasts, and what is going on in the economy?
Volodymyr Lepushynskyi, Director of Monetary Policy and Economic Analysis Department, National Bank of Ukraine
In 2015, the NBU began publishing a quarterly Inflation Report with a macroeconomic forecast. 21 April this year was the first time that the planned publication of this report had not taken place. As previously reported by the NBU, the decision on the key policy rate and the publication of the Inflation Report with a macroeconomic forecast has been postponed until the normalization of the economic situation.
What is the reason for breaking the traditions the economic community is accustomed to? And what are the NBU’s macroeconomists doing now?
Infinite number of scenarios
War is probably the only good reason to pause macroeconomic forecasting. With additional sources of uncertainty emerging – the duration and consequences of hostilities – it is impossible to make accurate predictions today. In peacetime, we used to partially resolve the problem of uncertainty by developing several alternative scenarios. As a rule, a scenario built on the assumptions that can materialize with a probability higher than 50% is designated as the baseline scenario.
In wartime, however, things are changing very quickly. The future is being decided right now – on the battlefield. Any forecast scenario carefully designed today may therefore lose its relevance tomorrow.
But under current conditions, it is not critical for the NBU to publish a macroeconomic forecast anyway. The main function of inflation-targeting forecasts is to show how the central bank will be able to return inflation to the target (5%) by applying its main instrument (the key policy rate). Accordingly, forecasts are one of the elements of managing expectations and building confidence in the central bank under the usual policy of inflation targeting.
At this time, the NBU has been forced to fix the exchange rate and has thus suspended inflation targeting. On the contrary, the fixed exchange rate is currently acting as an anchor to stabilize expectations. The advantage of a fixed exchange rate is its simplicity, in particular the absence of a need to have a complex system for informing the decision-making process, including through forecasts. However, it also has significant disadvantages that manifest themselves in the long run. That is why fixing the exchange rate is a temporary solution. The NBU will return to inflation targeting with the floating exchange rate and to the setting of the key policy rate based on forecasts. At the same time, we need to prepare for this.
Such preparation is conducted in two main areas. First, we are keeping tabs on the situation and analyzing it through alternative sources of information. Second, we are assessing the consequences of the war and the scenarios of post-war reconstruction.
Alternative sources of information
Even during the COVID-19 crisis, it became clear that the NBU needed more efficient and frequent data for monetary decision-making than official statistics could offer. Then the NBU stepped up efforts to search and process such data.
We have many ways to obtaining information: public and business surveys, electricity consumption, prices in online stores, data from job search sites, lighting intensity, and just ordinary news outlets.
We are now expanding this work, as the amount of official data has narrowed even more. For example, there are almost no official statistics on business activity, as businesses have been allowed not to submit reports and other documents to the State Statistics Service while martial law is in effect.
The main conclusion from the data is that the economy is in difficult conditions, but that it is adapting and operating. The economy is recovering in areas where the primary destructive factor – russian invaders – has been eliminated. Occupation and active hostilities now cover only six regions of Ukraine, which jointly account for 20% of GDP, down from the 10 regions that were occupied in March and that, together with Kyiv, provide 55% of GDP.
The main processes that signal recovery include:
- According to flash polls by the NBU, the number of businesses that have completely ceased operations has almost halved (to 17%, down from 32%) since the beginning of russia’s full-scale attack. But 60% of companies are operating below prewar levels.
- Almost one-third of companies currently have no problems with resources, while 48% of respondents said they will have enough resources for more than a month. The share of businesses that have had their reserves depleted has declined from March.
- Metallurgy is beginning to work. Machine-building is picking up, generating demand for metallurgy, agriculture, mining, and meeting the needs of the Armed Forces.
- The food industry is operating at full capacity in relatively quiet regions and is recovering in the liberated ones.
- Small and medium businesses are going back into operation. According to an EBA survey, only 26% of such businesses are currently shut down, compared to 42% a month earlier.
- The labor market is gradually recovering, although the number of jobseekers is growing faster than the number of vacancies, and the predominance of labor supply over demand leads to lower wages, which job seekers agree to. Lower wages are an unpleasant consequence of the war. But it is important that the labor market is now functioning and allowing businesses to adapt and find workers.
- Price pressure is elevated and uneven across regions. The main factor is the disruption of supply chains. The highest price increases have occurred in the regions temporarily occupied by russia and in cities with active hostilities. Where supply chains have been reestablished, the growth in prices has decelerated, and some goods have actually become cheaper. Not the least role in curbing inflation is being played by the simplification and reduction of import taxes, the fixing of the exchange rate by the NBU, and constant prices for utilities.
With how intense the events are right now, it is necessary to outline only the most obvious trends that will shape the development of the economy. After uncertainty eases, forecast scenarios will be built around such trends.
GDP. According to the NBU, GDP will fall by at least one-third this year. Losses can be greater if active hostilities drag on. At the same time, the very potential of the economy has suffered.
First, the russian invaders have destroyed important infrastructure, production facilities, real estate, and valuable movables. By the NBU’s latest estimates, Ukraine has lost about USD 100 billion in physical capital. For comparison, total GDP in the prewar year 2021 was approximately USD 200 billion.
Second, Ukraine does not have domestic sources for such a significant replenishment of capital. At the same time, we place our well-justified hopes in external sources of funding, both through confiscated russian assets and through support from international organizations, the EU, and bilateral assistance from countries.
Labor. The war has intensified migration processes. The UN estimates that five million people have fled the country. A distinction should be made between short-term and long-term consequences. With ties having been severed and production facilities and logistical routes having been destroyed, demand for labor will likely be low, leading to high unemployment and pressure on wages.
However, with the restoration and growth of production capacity, the situation will change: labor demand will increase, as will wages. Measures to encourage the return of migrants to Ukraine, such as tax incentives and retraining events, will play an important role. It is also expected that the role of total factor productivity (TFP) in the GDP potential will increase.
During the war, Ukrainians have once again demonstrated their ability to unite and make breakthrough changes. This is the foundation for the growing demand from the public for accelerating the necessary structural reforms in Ukraine after it wins the war. These reforms are well known and have long been part of the official rhetoric: protection of property rights, changes in the judicial and law enforcement systems, ease of doing business, and more.
Inflation. Inflationary pressures will remain stable in the long run and will arise from three main sources. The first source is the active change in relative prices (for some goods and services relative to others) because the very structure of the economy will change. For example, there will be changes in the structure of crops and changes in consumption patterns, as some products will be more in demand than others, etc.
The second source is increased pressure in the global markets due to russia's war in Ukraine. These are primarily energy and food prices. This pressure will pass through, both directly and through secondary effects, to domestic prices in Ukraine.
The third source of inflationary pressures is the recovery of demand in Ukraine amid limited opportunities to increase supply, as the economic potential has suffered.
These drivers of inflation are listed in the order of the NBU’s increasing ability to influence them, where such actions are viable at all. For instance, efforts to counter price increases due to structural changes may not work because the central bank’s instruments are not designed for this. On the contrary, in this case there is a risk of inflicting additional losses on the economy without achieving a material easing of price pressure. The economy therefore needs time to balance itself.
With regard to rising global prices, the NBU should prevent only secondary effects and an unbalancing of expectations. Meanwhile, combatting the last inflation factor – the overheating of the economy due to mismatches between supply and demand – is the NBU’s direct mandate.
The first and second inflation drivers will gradually decrease in intensity, while the last one will intensify. And so will the NBU’s capability to reduce inflation to its target.
Monetary policy will be aimed at ensuring low and stable inflation. As economic life normalizes, the NBU will have more and more leverage to achieve this.
The NBU has a fairly high inflation target (5%), which allows the economy to undergo structural change. Given the prospects for Ukraine’s fairly rapid integration into the EU and the specifics of the NBU’s monetary policy, Ukraine is likely to follow a scenario that has happened in Poland and the Czech Republic. It will include:
- The NBU will have to pursue a tight monetary policy to curb inflation after the economy undergoes a significant structural transformation. This will reduce inflation expectations and fix interest rates at low levels, thus ensuring the availability of hryvnia lending.
- Foreign currency that will come from external sources to finance economic recovery (reparations/reconstruction funds) will have to be actively purchased by the NBU to replenish international reserves and avoid sharp appreciation shocks. These efforts will also support domestic producers. At the same time, a moderate appreciation of the hryvnia under the conditions of FX supply dominance can become a significant disinflationary factor.
- The regulator will use its tools to manage a structural excess of banking system liquidity that will arise as a result of FX purchases by the NBU.
All these factors will be taken into account in the new macroeconomic forecast after returning to a relatively normal economic life. Hopefully, this will happen soon enough.