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We forecast a rate cut on 21 May

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to lower the CBI’s policy interest rate by 0.25 percentage points at its next rate-setting meeting, scheduled for 21 May, bringing to nulla close the longest period of unchanged interest rates since the adoption of the inflation targeting regime. We expect this to be the only rate cut of the year – and actually, the only rate change this year – as we think the MPC will decide to keep rates unchanged for the remainder of 2014.

The main grounds for a rate reduction are these: inflation is now below the CBI’s 2.5% inflation target and is expected to remain at or below target throughout the year, the bank’s new forecast is likely to provide for an improved inflation outlook, the ISK exchange rate has been stable since the last interest rate decision, and most of the recent wage agreements are broadly consistent with the inflation target.

MPC paved the way for a rate cut in March

As we had forecast, the MPC opened up the possibility of a rate cut at its last meeting, in March. According to the minutes of that meeting, the Committee had been considering either holding the policy rate unchanged or lowering it by 0.25 percentage points. In the statement announcing the 19 March decision, the MPC said that whether there was scope for a nominal interest rate reduction would depend on developments in inflation and inflation expectations in coming months. Members agreed that the inflation outlook had improved but that “the time to reduce rates had not arrived, as long-term inflation expectations were still markedly above the target.” All members voted in favour of the Governor’s proposal to keep rates unchanged.

What about inflation expectations?

The Governor has said, however, that although bringing inflation back to target now – and sooner than anticipated – is a welcome development, the most important goals are to keep it there for a sustained period of time and to reduce inflation expectations. He has expressed the opinion that if inflation expectations can be lowered, there will be grounds for a nominal policy rate cut.

By the time the MPC comes to a decision at its next meeting, it will have new data on market participants’ inflation expectations. The survey conducted by the CBI in early February suggests that the market expected inflation to measure 3.3% one year ahead. It is virtually a given that the new measurement of one-year inflation expectations will be lower than this, and relatively close to the target, as market agents’ inflation expectations have generally followed observed inflation rather closely. According to the February survey, respondents expected inflation to measure 3.6% two years ahead. The new survey will probably show a decline in this figure as well. It is possible that longer-term inflation expectations will also fall in the CBI’s survey. In February, respondents expected inflation to average 3.9% over the next five years.

Arguments in favour of an unchanged policy rate

This interest rate decision is more uncertain than its immediate predecessors. The uncertainty centres on the possibility that the MPC will decide to hold rates unchanged, as there are tenable grounds for such a decision. For instance, long-term inflation expectations are still somewhat above the inflation target, the breakeven inflation rate in the bond market has not fallen since the MPC’s last meeting, and the large wage increases negotiated by certain employee groups have caused a stir in the labour market, which could call forth pay hikes in excess of the inflation target during the next round of wage negotiations. We consider this last point to weigh rather heavily in keeping the policy rate unchanged later this year. Furthermore, we expect next year’s wage agreements to be less consistent with the inflation target than the current ones have been, which will tip the scales in favour of a rate hike next year.

Improved inflation outlook

The CBI plans to publish its new inflation forecast concurrent with the 21 May interest rate decision. The last CBI forecast was published on 12 February. So far this year, inflation has undershot the CBI’s February forecast, averaging null2.5% in Q1, while the CBI projected 2.7%. We expect a similar outcome in Q2, as the CBI’s February forecast provided for 2.8% inflation during the quarter, whereas we project it at 2.3%. We expect the bank to adjust its Q2 inflation forecast downwards.

We also expect the CBI to lower its forecast for the latter half of the year. We project Q4 inflation at 2.3%, somewhat below the CBI’s February forecast of 2.6%. We expect the improved inflation outlook for 2014 in comparison with the February forecast to be one of the MPC’s arguments in favour of a rate cut this month.

The CBI also plans to publish its macroeconomic forecast through 2016 on the next interest rate decision date. We assume the bank will revise its 2014 output growth forecast upwards from the February projection of 2.6%. Our own forecast, published in early May, provides for 3.2% GDP growth. In our opinion, the CBI’s February forecast was rather conservative in its assumptions concerning goods and services exports during the period. The CBI projected 1.4% growth, as opposed to our 3.7%. We also think the bank was cautious in its investment forecast for 2014, as it projected 5.4%, while we forecast it at 9.9%. More rapid growth this year means that the slack will disappear from the economy sooner than previously expected, which is an argument against a rate cut. Nonetheless, we think this will not carry much weight in next week’s interest rate decision.

Rate hike probable in 2015

As regards the longer-term outlook, the projections set out by the CBI in its February forecast are broadly similar to our own. Like the CBI, we expect GDP growth to be strong enough in the next two years to generate an output gap. Inflation will begin to rise next year and will be somewhat above target. Both of these factors are grounds for a policy rate hike. For the next two years, the CBI expects stronger GDP growth and higher inflation than we do. It could be that it will revise these projections downwards in its new forecast.

We expect that, after lowering the policy rate in May, the MPC will decide to keep it unchanged for the rest of the year. Then, as the output gap develops and inflation gains traction again, we expect the Committee to raise the policy rate by 0.75 percentage points next year, in three increments, bringing it to 6.5% by year-end 2015. We then expect one 0.25-point increase in 2016.

Easing the capital controls could necessitate a higher policy rate

Our policy rate forecast is based on the assumption that the capital controls will be eased during the forecast horizon in such a way as to avoid destabilising the foreign exchange market. The forecast assumes that the ISK will remain close to its current level throughout the horizon; however, this assumption is highly uncertain. It is conceivable that some steps will be taken to lift the capital controls during the forecast horizon, as the Government has proposed. If the steps taken are large, it can be assumed that they will call for a monetary policy response in the form of a higher policy rate and a wider interest rate spread in order to protect the exchange rate. If this does happen, the policy rate will rise more than we have projected during the forecast horizon.  

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