Our forecast: unchanged policy rate on 19 March

nullWe expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged at its 19 March rate-setting meeting. On the other hand, we expect the MPC to shift from its recent tightening tone and open the door for a possible rate cut in coming months. In our opinion, reduced inflation expectations, the recent drop in inflation, and the strength of the ISK all argue in favour of a change in tone. We expect the Governor to propose an unchanged policy rate and meet with sharply divided among MPC members, in a variation on the theme from the last interest rate decision, when one dissenter voted in favour of a 0.25-point rate hike instead of supporting the proposal to keep interest rates unchanged, which ultimately carried the day. We also expect the policy rate to remain unchanged throughout this year, but in a new twist, the uncertainty in this forecast is tilted to the downside.

Governor opens the possibility of a rate cut

nullSince 12 February, the CBI’s last interest rate announcement date, the Governor has intimated that the policy rate could be lowered, perhaps soon. Needless to say, this is a radical shift from the tone set in the MPC’s February statement, which said that according to the CBI’s inflation forecast, “it will be necessary to raise nominal interest rates as spare capacity in the economy disappears and an output gap emerges.”

Inflation has fallen from 3.1% to 2.1% since the February interest rate decision. A major factor there has been the recent appreciation of the ISK, which in turn is due partly to the CBI’s more assertive FX market intervention policy and the managed float regime adopted last May. Most indicators imply that inflation will be below the CBI’s inflation forecast of 2.7% in Q1/2014. Our own forecast is for 2.5% inflation during the quarter. The CBI assumed in its forecast that inflation would not return to target until the last quarter of the year, but clearly it will align with the target sooner.

In recent interviews, the Governor has said that, although bringing inflation back to target sooner than anticipated is always welcome, the most important goals are to keep it there for a sustained period of time and to reduce inflation expectations, which are still well above the inflation target. The Governor has expressed the opinion that if inflation expectations can be lowered, there will be grounds for a nominal policy rate cut.

Developments in inflation expectations support a change in tone

Inflation expectations declined on the heels of the drop in inflation in January and the expectation of modest wage increases this year. The short- and long-term breakeven inflation rates in the bond market fell by an average of 0.4-0.6 percentage points between the MPC’s meetings in December and February. By all of these measures, inflation expectations ranged between 3.3% and 3.7% just before the February meeting. Since then, however, the breakeven inflation rate in the bond market has fallen only slightly.

nullAccording to the Central Bank’s quarterly market expectations survey, conducted in early February, market participants expect inflation to be about 3.5% in two years’ time. This is a reduction of 0.5-0.7 percentage points from the November survey. On the other hand, longer-term inflation expectations among market participants are broadly unchanged and remain well above the CBI’s inflation target, averaging 4% over the next ten years.

By the time of its next meeting, the MPC will probably have received the findings from Capacent Gallup’s most recent quarterly survey of household and corporate inflation expectations. The previous survey was carried out in November, and the one whose results are forthcoming was conducted in late February. According to the November survey, household inflation expectations measured 5%, both one and two years ahead, and had remained unchanged for some time. According to a comparable survey conducted among corporate executives in November, respondents expect inflation to measure 3.9% in one year, down from 4% in the September survey. Developments in inflation since these surveys were carried out and changes in inflation forecasts over the same period give cause to expect the new survey to reveal a marked decline in inflation expectations.

Stronger output growth and less spare capacity

nullIceland’s GDP growth measured 3.3% in 2013, according to preliminary figures published by Statistics Iceland (SI) last week. This is somewhat above the CBI’s most recent forecast, which projected it at 3.0% for the year. Given that year-2013 GDP growth is now estimated to have been somewhat stronger than previously forecast, it can be assumed that the output slack has narrowed more than previously thought. In its most recent forecast, the CBI estimated last year’s slack in output at just under 1% of GDP, whereas the new figures put it closer to ½%. It is appropriate to point out that estimates of the output gap (or slack) are always subject to considerable uncertainty, not least when an economy is close to equilibrium, as is the case in Iceland now. It should be noted that the MPC has stated repeatedly in the recent term that as the margin of spare capacity disappears from the economy, it is appropriate that the slack in monetary policy should disappear as well; in other words, that the real policy rate should rise. The new output growth figures will therefore be grist for the mill of those MPC members who favour unchanged or higher interest rates.

Will the MPC change required reserve ratios and/or interest rates?

At a meeting of the Parliamentary Economics and Commerce Committee on 5 March, the Governor mentioned that reserve requirements could conceivably be used more effectively as a monetary policy instrument. He said that the possibility of increasing reserve requirements and/or lowering interest rates on reserve funds was under scrutiny. It was possible to cut interest rates on reserve requirements sharply, perhaps even lowering them to zero, thereby widening the banks’ interest rate spreads and tightening the monetary stance in that way. It would then be possible to reduce deposit rates as well, although it would mean widening the interest rate corridor. These options are being examined by the CBI and, according to the Governor, were discussed at the last MPC meeting, when Committee members received the first reports on the options available. They will be discussed again at the March meeting. We are of the opinion that the CBI is relatively satisfied with the current reserve ratios and interest rates. Even though the subject is under particular scrutiny by the MPC at the moment, we think it unlikely that any changes will be made in the near future.

Recent events undermine credibility of monetary policy

Following the MPC’s last interest rate decision and the publication of the CBI’s new macroeconomic forecast, which included a special assessment of the economic impact of the Government’s household debt relief package, the Prime Minister caused a stir by criticising the CBI’s prioritisation of its tasks, stating that the bank had undertaken the assessment without having been asked to do so. During the ensuing discussion, the Prime Minister reiterated his opinion that the policy rate is too high. This criticism has occasioned protest from the Governor and others.

In the midst of the fracas, the Ministry of Finance and Economic Affairs announced that the Governor’s position would be open for application for the upcoming five-year term, which begins this August. If no advertisement had been forthcoming, the current Governor’s tenure would have been extended automatically for another five years. The stated reason for this decision is the desire to give the authorities increased scope for possible amendments to the Central Bank Act. Concurrent with the announcement that the position would be advertised, it was stated that the Minister of Finance and Economic Affairs would appoint a work group to make an assessment of desirable amendments to the Central Bank Act. The group’s objective is to be to reaffirm the Bank’s credibility and independence and enhance confidence in the Icelandic economy.

It can be said that this entire chain of events has dealt a blow to monetary policy credibility. Furthermore, it is unfortunate that the Governor should begin to mention the possibility of a policy rate reduction in the immediate aftermath of this criticism of the CBI’s research priorities and interest rate decisions, even though there may be solid economic grounds to discuss rate cuts. Recent events and the entire discussion surrounding them have put the MPC between a rock and a hard place, as lowering the policy rate now or in the near future could be viewed as political plea-bargaining.

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. Our inflation forecast is broadly in line with the CBI’s forecast as regards 2014 and 2015.

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 at least one rate hike of 0.25 percentage points in 2016, bringing the policy rate up to 6.75%.

Uncertainties in the forecast

The uncertainty in the forecast is on the downside – i.e., the MPC could lower the policy rate now or in the immediate future. If it does cut interest rates, the ensuing tightening phase will probably be quicker once it begins. And although our forecast assumes that no steps will be taken towards capital account liberalisation during the forecast horizon, the possibility that some action will be taken during the period introduces a measure of uncertainty into our projections. In all likelihood, any easing of the controls would call for a higher policy rate – temporarily, at least.