In its latest meeting, Ukraines central bank kept its key interest rate at a seven-year high, while raising its inflation forecast for 2022. The news comes as Ukraine’s economy contracted by 40 percent in the second quarter of this year. The central bank also floated the idea of keeping the key rate at 25 percent until the second quarter of 2024. Despite the growing concern about Ukraine’s economic prospects, the key rate is still too low to prevent a major recession.
Meanwhile, the United States remains a key ally in the conflict against Russia. In May, U.S. first lady Jill Biden visited western Ukraine, and president Joe Biden signed the Lend-Lease Act to expedite $40 billion in military and humanitarian aid to Ukraine. As inflation continues to rise, Ukraine is concerned that a long-term war with Russia could destabilize the country.
Although the monetary transmission mechanism is a slow one, a change in the key policy rate can have a significant impact on inflation within nine to eighteen months. Therefore, the central bank’s monetary policy decision is not a reaction to recent events, but a forecast of what’s likely to happen in the next nine to eighteen months. Thus, when Ukraine raises its key rate, it is not responding to a past event, but to an expected future development.
Although the outlook for underlying inflation remains unchanged, it is stronger than what was anticipated a few months ago. Upstream cost pressures have boosted prices of new dwellings and consumer durables in recent quarters, and are now expected to continue longer than previously anticipated. The war in Ukraine and renewed lockdowns in China are expected to add to these effects. Moreover, these cost increases will hit many firms’ margins.
The European Union’s economic outlook has been dragged down by the Russian invasion of Ukraine. The Conference Board downgraded growth estimates for 2022 and 2023. Initially, it had forecast growth in the Euro Area at four percent – now it is estimated to reach only 2.7 percent. This is not a sign of a recession – the growth rate of the Euro Area has been growing at a healthy pace during the first quarter of 2022. The case for a possible recession relies on inflation hitting households, and supply bottlenecks resulting from the war in Ukraine.
The Russian invasion of Ukraine has strained global markets. The conflict in Ukraine has pushed prices of key commodities such as gas, oil, and other fossil fuels higher in Europe, with the recent increases adding new pressure to markets. Meanwhile, Russia is a major supplier of fossil fuels and has halted gas deliveries to a number of EU member states. Consequently, sanctions against Russian oil and gas exports have increased the cost of living and caused social unrest.
As a result, inflationary pressures are expected to continue in the near future as the country struggles to cope with the effects of the war. Meanwhile, the EU has approved six sets of sanctions aimed at Russia. The aim is to weaken its economic base and cut off its access to markets and critical technologies. If these challenges do not ease, the industrial output of the Euro Area could suffer.