We forecast an unchanged policy rate on 11 December
We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 11 December, the next interest rate announcement date. Our forecast is supported by two main factors: inflation has developed in line with the CBI forecast, and the króna has appreciated. Furthermore, the uncertainty surrounding the Government’s household debt relief proposals has been eliminated, and while there are signs that the package will increase inflation in the next few years, the effects are not strong enough to necessitate a rate hike now. The results of the wage negotiations currently in progress will be a major factor in subsequent interest rate decisions, but we do not expect the social partners to finalise a contract before the December policy rate announcement.
Inflationary debt relief measures
We expect the Government’s recently announced debt relief measures to stimulate GDP growth somewhat in the next few years, with the result that the slack in the economy will disappear sooner than previously anticipated. The measures will have a positive effect on households’ net wealth and disposable income, thereby boosting private consumption and household investment. But there will be side effects – including increased inflation, at least during the four-year horizon of the debt relief package – and the CBI can therefore be expected to keep the policy rate higher than would otherwise be needed.
The CBI did not factor the debt relief measures into its most recent macroeconomic and inflation forecast, published concurrent with the 6 November policy rate decision. Because the scope, timing, and execution of the measures were uncertain, the CBI opted to omit them from the forecast. The proposals have now been presented, and it is clear that elevated inflation is among the side effects. In view of this, the inflation outlook has deteriorated since the MPC’s last interest rate decision, although one source of uncertainty has been eliminated.
Collective bargaining agreements awaited
In our opinion, the results of the ongoing wage negotiations will influence the interest rate decision immediately following. The MPC has stated explicitly that if pay increases are in line with the CBI forecast (and therefore in excess of the bank’s inflation target), it will probably respond with a rate hike. The tone taken so far in the wage negotiations indicates the likelihood of a short contract, perhaps for a term of one year. Furthermore, the emphasis appears to be on preservation of real wages and on State involvement in the wage agreements rather than on massive nominal pay increases. In this light, the possibility still exists that the contracts ultimately negotiated will be within the limits defined by the CBI. We consider this a less likely outcome than the alternative – i.e., that the wage settlements coupled with the Government debt relief package will call for a policy rate increase – but in any case, we think it unlikely that the wage agreements will be concluded before the 11 December interest rate announcement.
Exchange rate broadly in line with CBI inflation forecast
In terms of the trade-weighted exchange rate in the domestic market, the króna has strengthened by about 1.8% since the 6 November interest rate announcement. The appreciation is doubtless due to considerably more favourable developments in the underlying current account balance this year than in 2012, owing in part to a smaller underlying income account deficit, which in turn stems from a year-on-year reduction in foreign loan interest expense. The increase in tourism-generated revenues and growth in marine product export volumes have contributed as well. In addition, foreign debt service has declined year-on-year, and stockpiling of foreign currency has diminished as well. The ISK exchange rate is now very close to the level assumed to prevail throughout the forecast horizon in the CBI’s 6 November inflation forecast. The exchange rate according to the narrow trade-weighted index (TWI) was set at 215.6 during the forecast horizon but is now 216.2, only 0.3% weaker than in the forecast.
Inflation evolving in line with CBI forecast
Inflation has risen from 3.6% to 3.7% since the CBI’s last interest rate decision date. The 0.36% rise in the CPI in November somewhat outpaced expectations. We expect inflation to measure 3.8% in Q4/2013, in line with the CBI forecast. Looking further ahead, however, we are notably more pessimistic than the Central Bank is. We project year-2015 inflation at 3.7%, while the CBI forecasts 2.7%. It is worth mentioning that the CBI has systematically underestimated inflation in its long-term forecasts.
The CBI has generally measured the monetary stance in terms of the real policy rate. According to the bank, the effective nominal policy rate should be close to the simple average of the CBI’s current account rate and the maximum CD rate. Given that the nominal policy rate has remained unchanged and inflation has risen since the last rate-setting meeting, the real policy rate has fallen from 1.8% to 1.7%. The monetary stance has therefore eased slightly since the last MPC meeting.
Forecasts in sync
GDP figures for Q3/2013 will be published at the end of this week, in advance of next week’s MPC meeting. GDP growth measured 2.2% in the first half of the year, and the CBI projects it at 2.3% for the year as a whole. Based on recent indicators of developments in GDP, we expect growth for the year to be slightly below the CBI forecast. For the following two years, we project it at 2.6% in 2014 and 2.7% in 2015, which aligns closely with the CBI’s forecast of 2.6% in 2014 and 2.8% in 2015. We expect, as the CBI does, that the slack in the economy will disappear in 2015.
Two policy rate hikes in 2014
We expect the MPC to raise the policy rate next year, once GDP growth has gathered pace and inflation has proved to be more persistent than in the CBI’s inflation forecast. The MPC has stated repeatedly in recent statements that “as spare capacity disappears from the economy, it is necessary that monetary policy slack should disappear as well.” Unlike the CBI, we are convinced that this adjustment will take place through nominal policy rate hikes rather than through disinflation. We forecast that the MPC will raise the policy rate by 0.5 percentage points next year, in two 0.25-point increments, and we expect another rate increase of 0.25 percentage points in 2015.