What monetary policy follows the National Bank?

Murat TemirkhanovJanuary 17, 2018

Base rate reduction immediately by 0.5 percentage points to 9.75% came as a surprise not only for us. According to a survey conducted by Bloomberg, 6 out of 10 of those polled economists believed that the monetary regulator wouldn’t change the base rate. And 4 expert expected the rate to fall to 10.0%. Overall, we have quite a positive look at the cut of the base rate, but we believe that the decision of the National Bank is contradictory to its policy – “inflation targeting”. This contradiction carries some serious risks and, in our opinion, the regulator should take steps to eliminate such discrepancies.

The National Bank has moved away from traditional policy - inflation targeting

In the guidelines for monetary policy of the National Bank for 2018 it states:

"The channel of expectations is no less important, reflecting the impact of Central Bank policy changes on expectations of economic entities. The Central Bank's statements form beliefs about the trajectory of interest rates in the short- and long-term and the dynamics of future inflation. Expectations of future inflation are shaping the behavior of participants already in the current period, exerting influence on aggregate demand. The higher is the transparency of the Central Bank and the awareness of market participants on further actions, the higher is confidence of economic entities in monetary policy and lower are inflation expectations."

In accordance with the monetary policy pursued by the National Bank in the inflation targeting regime, we expected that the base rate will remain unchanged in January. Our expectations were based on the fact that in this regime very important factors for the decision were: the current level of inflation, moderation of its volatility, and the dynamics of the population's inflationary expectations and the market participancts. Among the first two factors we haven't seen any progress and in regards of inflationary expectations in the fourth quarter of 2017 there was a significant negative development.

Inflation in 2017 was 7.1%, however, there are certain doubts about the reliability of the data due to dramatically weakening inflation in December 2017. Traditionally at the end of the year amid increased demand in  New Year’s eve, prices tend to spike for food and non-food items. In response to the increased devaluation expectations, we predicted a monthly increase in inflation in December 2017, but statistics showed the opposite trend (0.7% in December, against 0.9% in November).

According to polls conducted by the National Bank, from February to November 2017, inflationary expectations quite steadily grew with a noticeable acceleration in October and November, when the actual monthly inflation sharply increased. In November amid rising prices for fuel and food, inflationary expectations directly for the next month - December 2017 rose abruptly. Increased demand, accompanied by elevated inflationary expectations had to lead to higher inflation, but it happened the other way around. Even assuming that in December the monthly inflation has fallen, in any case, its growth in October and high level in November say about instability and high volatility of inflation.

According to traditional monetary policy - inflation targeting, rising inflationary expectations and high volatility of inflation should constrain monetary policy easing in the form of lower key rates by the Central Bank. That is why most experts predicted the maintenance of National Bank's base rate at the same level. From this point of view, high risk of the dramatic reduction in base rate (in contrast with the inflationary targeting) is to lose the reliability of economic entities on the monetary policy conducted by the National Bank.

Not quite correct reasoning of the National Bank over the cut in the base rate may also reduce confidence. . In particular, in its recent decision to reduce the base rate regulator said. "The perception by population of price changes is improving." (...)"Quantitative evaluation of inflation expectations for the next year declined from 7.6% in December 2016 to 7.1% in December 2017."

At the same time, the National Bank in its October statement on base rate mentioned. "A quantitative estimate of inflation for the year ahead in September has not changed (6.5%) and is within the target corridor for 2018." In the November decision on the base rate an increase in inflation expectations were already noted. In October, the quantification of inflation expectations for the year ahead rose to 6.9% in the wake of rising prices on energy and food market.

Thus, given December's inflation expectations (7.1%), the last three months of 2017 passed in anticipation of growth in annual inflation, which contradicts the statement of the National Bank on improving the perception of price changes by people.

It is necessary to adjust the monetary policy of the National Bank

In spite of the fact that the decision of the monetary regulator is contrary to the traditional policy -inflation targeting, we're fairly positive on such a cut in the base rate. As noted in a recent decision of the National Bank on the base rate, significant inflation risks can be realized on the supply side, regardless of his policies.

We fully agree with that remark and believe that, despite increased inflationary expectations, a fairly sharp decline in base rate should not lead to the growth of inflation on the demand side that is related to the continuing decline in real incomes and a reduction in the use of funds of the National Fund in the State budget in 2018. At the same time, reduction of the base rate will stimulate lending growth and, consequently, economic growth.

One thing that causes concern about a sharp cut in a base rate is a significant increase in unsecured consumer lending, which occurred last year. When there are declining real incomes, the rapid growth of such lending can have quite serious consequences both for the banking system and the State.

On the other hand, the inconsistency of actions of the National Bank with traditional policy - inflation targeting will lead to a decline in confidence towards the monetary regulator that is another factor that will push inflation and could lead to an increase in dollarization of deposits.

We believe that the National Bank must formally announce changes in its monetary policy so that its actions are consistent with the rule of the central banks "tell what you're doing, and do what you say".

In general, it may be noted that the reduction of key rates for the growth of the economy, with volatile inflation and rising inflationary expectations, largely corresponds to monetary policy - targeting of nominal GDP. In accordance with this policy (compared to inflation targeting) currency free floating, as well as the management of the base rate and expectations of the population and the market remain unchanged. At the same time, the National Bank appears to have in fact, a "dual mandate" without contradiction of targets. The key difference of this monetary policy of inflation targeting, in terms of "dual mandate" of the Central Bank is that it allowed higher inflation in the short term, especially when it relates to mean "cost push inflation" (supply-side inflation).

From this point of view, it is possible that, the National Bank should again consider the transition from inflation targeting to nominal GDP targeting.