Our forecast: unchanged policy rate on 12 February

nullWe forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to hold the policy rate unchanged at its 12 February rate-setting meeting. We expect the Committee to soften the tone it takes in its statement, however, and move away from its recent tendency to suggest that a rate hike is in the wings. We now expect the MPC to keep the policy rate unchanged throughout the calendar year, as it did in 2013. If this forecast materialises, it will be the longest period of unchanged CBI interest rates in decades. This forecast represents a change from our stance hitherto, as we have previously projected that the MPC would raise rates this year.

Numerous factors converge to defuse inflation

nullInflation has fallen appreciably since the MPC’s last rate-setting meeting, and most indicators for Q1 imply that it will be well below the CBI’s last inflation forecast. We project 2.6% average inflation in Q1, whereas the CBI’s last forecast provides for 3.3%. In conjunction with the upcoming interest rate announcement, the CBI will publish its updated inflation forecast, which we expect to be brighter than the last one. The króna has appreciated since the last interest rate announcement and is now a good 3% stronger than the CBI assumed in its last forecast. This will tend to shift the inflation forecast downwards. Furthermore, the output growth forecast has deteriorated, as it now looks less likely that the energy-intensive industrial development projects the CBI assumed in its most recent forecast will materialise. Added to this, exports could turn out weaker this year than in the CBI forecast, owing to poorer-than-expected capelin catches, and the newly concluded wage agreements indicate that unit labour costs could rise somewhat less this year than in the CBI’s last forecast. And last but not least, the real policy rate has risen markedly, suggesting that the slack in monetary policy has disappeared.

Inflation below target in February

The outlook is for further disinflation in coming months. We project that inflation will fall to 2.3% in February and then rise to 2.5% in March and 2.6% in April, leaving it within striking distance of the CBI’s inflation target over the next few months. We expect the CBI’s 12 February inflation forecast to be broadly in line with our own.

Milder tone

In view of these factors, we anticipate a new tone in the MPC’s next statement. We expect that, instead of suggesting an imminent rate hike that has characterised recent MPC statements, the MPC will take a more neutral stance, citing the improved inflation outlook and the unexpectedly rapid disappearance of the slack in the economy.

Rate cut in the offing?

All of these arguments give rise to the question of a possible policy rate reduction next week. We think this highly unlikely, however. Inflation is still above target, and even though it has tapered off, the CBI will doubtless want to see it securely at target before embarking on any monetary easing. And even though the slack in the economy is narrowing, it could disappear somewhat more slowly than the CBI has previously projected. In any case, the MPC has demonstrated that it is cautious and conservative in its decisions, and we see no reason for that to change now.

Scope for lower rates

nullThe real policy rate has risen rapidly in the recent past, from -2.3% two years ago to the current +2.4%, in terms of past inflation. According to our inflation forecast, it will rise to 3.2% in February. Recent MPC statements have emphasised that as spare capacity disappears from the economy, it is appropriate that slack in monetary policy should disappear as well. The problem is, however, that the slack in the economy has not disappeared, and recent developments indicate that it may take some time to do so. As a result, it can be said that the slack in the monetary stance has disappeared too suddenly and that there is now scope for a lower policy rate.

In view of this, we think it conceivable that the MPC will lower the policy rate this year, perhaps in March or May. But uncertainties abound, specifically to include the upcoming private and public sector wage agreements and the ever-present uncertainty about the exchange rate. In consequence, we consider it more likely that the MPC will hold the policy rate unchanged throughout this year.

Rate hike probable in 2015

We expect the current disinflation episode to prove temporary, given that it stems in part from the recent appreciation of the ISK. Underlying factors indicate the presence of some long-term inflationary pressures, and we expect inflation to pick up again and rise above the target later this year.

While we project an unchanged policy rate this year, we expect the MPC to raise rates by 0.5 percentage points in two increments in 2015, owing to rising inflation and the disappearance of spare capacity in the economy. On the same grounds, we forecast a single rate hike of 0.25 percentage points in 2016, bringing the policy rate up to 6.75%.

Uncertainties in the forecast

The uncertainty in our forecast is mainly on the downside: that the MPC will decide to hold rates unchanged longer than we anticipate and perhaps decide to lower them in the first half of this year. If the Committee does cut interest rates, the ensuing tightening phase will probably be quicker once it begins. The uncertainty profile of our forecast has changed radically in the recent term, as the possibility of a rate cut has entered the picture and the imminent threat of a rate hike has all but vanished.