Our forecast: unchanged policy rate on 11 June

nullWe expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 11 June, the next announcement date. The last policy rate announcement was on 21 May and the interval between meetings therefore unusually short. On 21 May, the Committee decided to keep the policy rate unchanged, citing as its main rationale the increase in the Bank’s real rate year-to-date, which in turn was due to declining inflation and inflation expectations. Since that decision was announced, nothing has occurred to call for a change in the MPC’s view of the optimum monetary stance; therefore, it is likely that the Committee will cite similar arguments this time.

The CBI’s real policy rate is now close to equilibrium after a marked rise year-to-date; moreover, inflation is at target, the ISK stable, and the slack in the economy virtually gone. Inflation expectations have been falling, although long-term expectations are still somewhat above target. We forecast that 2014 will be a year of equilibrium and that the MPC will keep the policy rate unchanged all year long. On the other hand, we project, as does the CBI, that an output gap will develop in coming quarters, with mounting inflationary pressures, which will call for a tighter monetary stance in the form of a higher real policy rate. As a consequence, we expect the MPC to respond by raising the nominal policy rate next year.

Inflation at target

Inflation has been below the CBI’s inflation target since February of this year. It is now 2.4%, up from 2.3% at the time of the last rate-setting meeting. The outlook for this year is good. We expect inflation to remain below target in coming months and to end the year just below it. If our forecast materialises, this will be the longest period of target-level nullinflation in a decade. The main contributors to this season of calm are the stability of the ISK and modest domestic cost price increases. Foreign inflation has been very low as well.

At present, the main driver of inflation is house prices, which have risen swiftly in recent months, with the twelve-month increase in market values measuring 9.7%. The housing component is responsible for just over half of inflation at present, as inflation excluding the housing component measures only 1.1%. We expect this pattern to continue, with housing as the main driver of inflation throughout the year.

The CBI projects, as we do, that inflation will gather pace in 2015 and rise above 3% as the output gap develops. According to the CBI’s forecast, inflation will lie in the 3.0-3.5% range in the latter half of the forecast horizon (which extends until 2017) and then begin subsiding to target in response to a tighter monetary stance. The CBI’s forecast assumes that the nominal policy rate will rise during the period, and its long-term forecast is well in line with our own. It is worth noting, though, that according to the minutes of the MPC’s last meeting, some members thought it possible that inflation was overestimated in the forecast, pointing out that developments in imported inflation were uncertain and global inflation low.

Q1 national accounts forthcoming

GDP growth has been relatively strong in the recent term. It measured 3.3% in 2013, and we expect it to hold broadly steady this year, at 3.2%. The CBI’s new macroeconomic forecast, published concurrent with the 21 May interest rate decision, is more optimistic than ours, as it nullestimates year-2014 growth at 3.7%. The CBI’s 2015 output growth forecast is also higher than ours, at 3.9%, as opposed to our 3.3%. The forecasts are nonetheless similar in that both provide for a growing output gap, with mounting inflationary pressures.

The national accounts for Q1/2014 will be ready by the time the MPC meets again. Currently available figures on payment card turnover, imports, and exports suggest relatively strong growth during the quarter. The MPC will naturally take note of this. Nevertheless, we expect the figures to be well within the boundaries of the CBI’s forecast and do not anticipate that they will change the MPC’s view of the appropriate monetary stance at this time.

Solid arguments for either an unchanged policy rate or a rate hike

At its last rate-setting meeting, the Committee unanimously supported the Governor’s proposal to keep the policy rate unchanged. Members agreed, however, that there were grounds both for keeping interest rates unchanged and for raising them. The strongest argument in favour of a rate increase discussed at the meeting centred on the benefits of responding swiftly, as the slack in the economy is now expected to disappear in mid-2014, about half a year earlier than was forecast in February. There are also signs of wage pressures in the labour market and possible difficulties related to next year’s wage negotiations. Even though the near-term inflation outlook has improved, the long-term outlook has deteriorated. Long-term inflation expectations are still close to 4% and have changed little in spite of favourable developments in inflation in the recent term. The tone of the MPC minutes from May is somewhat sterner than that in the statement announcing the interest rate decision. This supports our projection that the MPC’s next rate change will be an increase taking place early in 2015. The uncertainty in that forecast appears to be related to timing; in other words, the rate hike could come sooner than we expect.

Long-term inflation expectations still well above target

The five- and ten-year breakeven inflation rate in the bond market was about 4% just before the MPC’s May meeting. It has changed little since then. At its last meeting, the MPC had at its disposal the findings from the CBI’s most recent survey of market participants’ inflation expectations. According to the survey, short-term inflation expectations have tapered off since the previous survey, conducted in February. On average, market participants expect twelve-month inflation to be close to target through end-2014. They expect it to measure 3.1% in one year and 3.5% in two years. However, their longer-term inflation expectations are broadly unchanged from the February survey, averaging 3.8% over the next ten years.

ISK exchange rate stable

The ISK has been stable since the MPC’s last meeting. It has actually been extremely stable in recent months, after having risen somewhat last winter. By and large, the CBI appears to be content with the current nullexchange rate. The ISK has appreciated enough to bring inflation back to target. Further appreciation and the associated rise in the real exchange rate would exacerbate the balance of payments problem  in coming quarters. With this in mind, the CBI has been active in the interbank foreign exchange market, buying a significant amount of FX so as to shore up its non-borrowed reserves and prevent further appreciation and exchange rate volatility.

The future path of the exchange rate is difficult to predict, in view of Iceland’s balance of payments problem, uncertainty about the settlement of the failed banks’ estates, and the anticipated liberalisation of the capital controls. It can be said that this is the most salient uncertainty in our long-term policy rate forecast – and our inflation forecasts as well. 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 also assumes that the ISK will remain close to its current level throughout the horizon. 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.

Rate hike probable in 2015

Like the CBI, we expect GDP growth to be strong enough in the near future 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. We expect the MPC to decide to keep the policy rate unchanged until next year. That said, we expect a nominal monetary tightening phase to begin early in 2015, with three rate hikes totalling 0.75 percentage points over the course of the year. This would bring the policy rate to 6.75% by year-end 2015. We then expect one 0.25-point increase in 2016.