Next policy rate change will be an increase

The Central Bank (CBI) Monetary Policy Committee (MPC) decided today to keep the bank’s policy interest rate unchanged. Forecasters nullanticipated either an unchanged policy rate or a 25-basis point rate cut. Our own forecast provided for a rate cut of 25 bp. According to the MPC, the future path of inflation and inflation expectations will determine whether a change in the Bank’s nominal interest rates is warranted in the near future. The Committee gives no indication of whether such a change would be an increase or a decrease, but we think it likely that the next policy rate change will be a rate hike.

Real policy rate needs to rise in the near future

In its statement, the MPC says that, other things being equal, increased near-term growth in domestic demand will require the real Central Bank rate to rise still further. If the real policy rate is estimated based on developments in inflation, and if inflation develops in line with the CBI’s forecast or our own, it is clear that the next policy rate change will be an increase. We expect the MPC to hold the policy rate unchanged through this year and then raise it in 2015 and 2016.

Slack gone

The Bank’s effective real rate is now about 3% in terms of the current inflation level and 2.3% in terms of the average of various measures of inflation and short-term inflation expectations. The CBI’s real rate has risen in tandem with the recent decline in inflation. According to the MPC statement, the slack in the monetary stance has probably vanished by now. The bank also says that the spare capacity in the economy is all but gone. Recent developments are therefore in line with the tone of recent MPC statements; i.e., that it is appropriate to withdraw monetary accommodation as the slack disappears from the economy.

Stronger output growth expected

nullThe CBI published its new macroeconomic forecast concurrent with today’s interest rate decision. The bank now estimates year-2014 GDP growth at 3.7%, a full percentage point higher than the projection at the time of the last interest rate decision. The CBI now forecasts GDP growth at 3.9% in 2015, as opposed to the previous 3.7%. This is quite a bit above our own forecast of 3.2% for 2014 and 3.3% for 2015. The main difference between our forecast for 2014 and the CBI’s forecast lies in projections of investment, business investment in particular.

Inflation forecast revised downwards

The CBI has revised its inflation forecast downwards. It now projects average year-2014 inflation at 2.5%, as opposed to 2.7% in its last forecast. For 2015, the CBI forecasts average inflation at 3.1%, as compared with its previous projection of 3.4%. The CBI’s inflation forecast is still somewhat above ours for most of the forecast horizon. This should not take anyone by surprise, given the tenor of the GDP growth forecast. According to the CBI’s forecast, inflation will be above target for most of the forecast horizon, but well below the upper tolerance limit of 4%.  

Changes made to CBI policy instruments

The CBI has also announced changes to its monetary policy instruments. The changes are intended to enhance the effectiveness of the CBI’s liquidity management and, to the extent possible, promote greater efficiency as regards its balance sheet. They should also prepare for the changes in the monetary policy environment upon the sale of Central Bank of Iceland Holding Company (ESÍ) assets and the liberalisation of the capital controls. CBI Governor Már Guðmundsson stated at this morning’s press conference that further changes in monetary instruments are expected in the near future. In our opinion, these changes represent the equivalent of a reduction in market interest rates and can be viewed has having taken the place of a rate cut this time.

Bond market response

Yields on nominal Treasury bonds rose by up to seven points after the market opened today but have retreated to a large extent over the course of the morning. Turnover has been strong with bonds at the middle of the yield curve but has been limited in other respects. This activity indicates some expectation of a rate cut but suggests that the market’s assessment of the real near-term interest rate level changed upon closer examination of the CBI’s statements and actions. It is also worth noting that, at the press conference, the Governor placed considerable emphasis on the uncertainty about the output slack or gap, and therefore about where the CBI’s [neutral] real rate should be in the near future.