The National Bank of Ukraine (NBU) added it may continue to raise the rate if inflation continues to rise.
The rate hike by the NBU wraps up an easing cycle that began in August 2015 and ended in May 2017 after the rate was cut by a total of 1,750 basis points from 30.0 percent. It is the central bank's first rate hike since March 2015.
Since May inflation has been risen steadily and the NBU said today's rate hike primarily was aimed at preventing inflation expectations from deteriorating even further, restrain buoyant consumer demand, and a response to the growing risks of delays in the country's critical cooperation with the International Monetary Fund (IMF).
"The tight monetary policy will bring inflation close to the central point of the target range in Q3 2018," the NBU said, adding higher interest rates will also have a positive effect on inflation via the exchange rate as domestic currency assets will become more attractive than foreign currency assets.
Ukraine's inflation rate accelerated for the fourth month in a row to 16.4 percent in September from 16.2 percent in August, boosted by faster growth in raw food prices - such as fruits, vegetables, meat and dairy products - higher production costs and a revival of consumer demand.
Inflation has picked up this year as the minimum wage was doubled and the government launched a series of initiatives to boost household income.
Although fiscal policy and a rise in the exchange rate of Ukraine's hryvnia helped curb inflation, the NBU revised its inflation forecast and now expects it to only decline to 12.2 percent by the end of this year instead of 9.1 percent as previously thought.
"Inflation will decelerate and approach its target levels. However, this process will be slower than forecasted earlier," the central bank said.
By the end of 2018 inflation is now seen decelerating to 7.3 percent instead of reaching 6.0 percent.
For 2019 the NBU still expects inflation of 5.0 percent, with administered prices expected to rise by 10 percent over the next two years, mainly due to a gradual increase in global energy prices and a harmonization of Ukrainian tobacco excise taxes with those in the European Union.
Private consumption will continue to drive Ukraine's economic growth in coming years due to higher wages and pensions, improved sentiment and consumer lending.
The NBU raised its 2017 economic growth forecast to 2.2 percent from 1.6 percent, and for 2018 and 2019 the economy is seen speeding up to 3.2 percent growth and 3.5 percent, respectively.
Ukraine's economy grew by an annual rate of 2.3 percent in the second quarter of this year, slightly down from 2.5 percent in the first quarter.
Strong consumer demand will push up imports but the NBU also expects exports to rise as metallurgical companies return to previous output levels, food production remains high and there are favorable external conditions.
The NBU expects Ukraine's current account deficit to remain around US$4 billion this year and through 2019 and be fully offset by financial inflows.
But much of the central bank's optimism rests on continued cooperation with the IMF, which has provided financial support to Ukraine over the last 20 years. The most recent agreement was struck in March 2015 when the IMF approved a 4-year, $17.5 billion facility, with the first two tranches paid out.
The third tranche, worth $1billion, has been held up over due to disagreements over progress in rooting out corruption and modernizing the economy, but the central bank said it expects this tranche to be received in the first quarter of next year, a move that will help boost Ukraine's international reserves to US$22.2 billion, or 4.2 months of imports.
After tumbling in 2014 and 2015, the hryvnia has been more stable since March 2016 and risen against the U.S. dollar this year on better global conditions for Ukrainian export commodities.
But a fall in the exchange rate since late August was "mostly driven by situational factors and they impact that previous years' seasonality had on economic agents," the NBU said.
The hryvnia was trading at 26.8 to the dollar today, up 0.7 percent this year, with the NBU confirming it has been smoothing out sharp fluctuations in the exchange rate.
The National Bank of Ukraine issued the following statement:
"The Board of the National Bank of Ukraine decided to hike its key policy rate to 13.5% per annum, effective from 27 October 2017. A tighter monetary policy will contribute to lowering headline inflation and bringing it closer to the target in 2018.
In September 2017, headline inflation accelerated to 16.4% yoy, which exceeded the NBU forecast published in the July Inflation Report. This was primarily driven by a quicker growth in raw food prices, higher production costs, and a revival of consumer demand.
Same as previous months, supply factors contributed to rising domestic prices for fruit and vegetables, meat and dairy products at fast paces.
By influencing the cost of highly processed foods, the growth in raw food prices had an indirect impact on core inflation (7.7% yoy), which also exceeded expectations.
In addition, higher service prices also contributed to a rise in core inflation as a result of cost increases, including due to bringing wages out of the shadow as the minimum wage was doubled early this year.
An anticipated pickup in consumer demand also contributed to the core inflation acceleration. This was primarily driven by increased household incomes as wages in the private sector were raised on the back of high demand for labor. Another reason was the consumer confidence gradually improving thanks to the social initiatives announced by the government.
Rather prudent fiscal and monetary policies curbed core inflation. The FX market also put no pressure on the inflation levels. In general, the fundamental factors (namely, the external conditions favorable for Ukrainian exports) remained in force, having contributed to the hryvnia strengthening against the US dollar during most of the year. The September–October weakening of the exchange rate was mostly driven by situational factors and the impact that previous years’ seasonality had on economic agents. Apart from that, the NBU smoothed out sharp fluctuations.
After a lasting trend for improvement, inflation expectations deteriorated over the recent months. Based on surveys conducted among households, banks, and financial analysts in September-October, the NBU observes an increase in the expected price growth rates for the following 12 months. The deterioration of expectations is driven by the current high growth rates of prices and the announced substantial increase in social standards.
Inflation will decelerate and approach its target levels. However, this process will be slower than forecasted earlier.
The NBU has revised the inflation forecast for 2017 and 2018 as inflation accelerated over the recent months and new inflation factors appeared (in particular, a stronger pickup in consumer demand, a rapid growth in pension payments, the minimum wage, excise taxes on tobacco products, etc.).
Inflation is projected to decelerate to 12.2% by the end of 2017 (9.1% according to the previous forecast).
It will continue to slow down and will be close to the central point of the target range in Q3 2018. Inflation is projected to reach 7.3% at the end of 2018 (6.0% according to the previous forecast).
Inflation projections for 2019, at 5.0%, have remained unchanged.
Inflation is expected to decelerate in 2018 - 2019, due to the NBU conducting a relatively tight monetary policy, the effect of a sharp consumer price rise fading away, and the exchange rate being only moderately volatile. Both raw food price growth and core inflation, which significantly depends on the former, will slow down. Overall, fundamental inflation pressure will be modest on the forecast horizon.
The largest increase in inflation components in 2018 - 2019 will be in administrated prices, which are expected to rise by over 10% a year. This will be mainly due to the expected gradual growth in global energy prices, which will pass through to domestic prices, and harmonization of the Ukrainian tobacco excise taxes with the EU rate.
Ukrainian economic growth in 2017 will be stronger than expected.
The NBU has revised its 2017 economic forecast upward (from 1.6% to 2.2%). This was the result of a more favorable than expected effect from both internal and external factors on the economic performance of most sectors in Q2 and Q3 of the current year.
GDP growth is expected to speed up to 3.2% and 3.5% in 2018 and 2019 respectively. Private consumption will continue to be the main driver of economic growth in these years, thanks to higher wages and pensions, better consumer sentiment, and a pick-up in consumer lending.
Imports will rise further, driven by a pick-up in consumer demand, higher investment and an increased need for imported energy carriers. Exports will also grow, due to, among other things, the expected return of metallurgical companies to their previous production levels, favorable external conditions, and the large output of the food industry.
In this light, the current account deficit will continue to hover around USD 4 billion in 2017 - 2019. It will be fully offset by financial account inflows.
A key assumption of this forecast is that Ukraine will continue to cooperate with the IMF. An overall balance of payments surplus, together with other tranches received under the EFF, will push up international reserves further.
The NBU expects that next EFF tranche will be received in Q1 2018. Along with a surplus of the overall balance of payments, this is expected to drive international reserves up to USD 22.2 billion or 4.2 months of future imports by the end of 2018.
The NBU, however, sees a number of risks to this forecast.
The temporary supply factors that drove up raw food prices this year and caused consumption to pick up further amid higher social standards could increase fundamental pressure on inflation.
In addition, the Ukrainian economy could become more vulnerable if external official financing under the EFF is delayed.
With the aim of bringing inflation to the inflation targets and taking into account the above risks the NBU deems it necessary to hike the key policy rate, up to 13.5% per annum.
Tighter monetary policy is primarily aimed at preventing inflation expectations from further deterioration. Moreover, tighter monetary stance is a response to higher risks of delays in resumption of cooperation with the IMF and faster expansion of consumer demand owing to rising social standards.
Tighter monetary policy will help curb inflation through several channels. A rise in key police rate will facilitate an inflow of savings into the banking sector and, therefore, restrain consumer demand. Also, higher interest rates make financial instruments in domestic currency more attractive than those in foreign currency, which will have a positive effect on inflation via the exchange rate channel.
The tight monetary policy will bring inflation close to the central point of the target range in Q3 2018.
The NBU Board is confident that the achievement of price stability is key to sustainable economic growth. Steady improvement of inflation expectations is a major factor in reducing banks' interest rates in the medium term.
In the event of realization of the above inflation risks, the NBU may further raise the key policy rate to offset their effects and return inflation to its target path.
However, in case of deceleration of inflation according to the forecast, further cooperation with the IMF, and pursuing prudent fiscal policy, the NBU may return to the easing cycle of monetary policy at the end of 2018.
The decision to raise the key policy rate to 13.5% is approved by NBU Board Decision On the Key Policy Rate No. 688-D, dated 26 October 2017.
The next meeting of the NBU Board on monetary policy issues will be held on 14 December 2017 as scheduled."
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