Unchanged interest rates in line with forecasts

nullThe Central Bank (CBI) Monetary Policy Committee (MPC) has decided again to keep the policy rate unchanged, in line with our forecast and others. The grounds for the decision included the fact that inflation has been close to target in recent months and, according to the CBI’s forecast, appears likely to remain there into next year. In addition, inflation expectations one and two years ahead have declined in the recent term. The drop in inflation and inflation expectations implies a marked increase in the CBI’s real rate so far in 2014.

Q1 national accounts figures make no impact

In the CBI press conference announcing the decision, the Governor said that the situation was broadly unchanged since the MPC’s last interest nullrate announcement, on 21 May. The main new information came from the Q1 national accounts figures, which showed a contraction of 0.1% during the quarter. The Governor said that the new figures did little to change the situation described in the May issue of Monetary Bulletin, in which the CBI projected year-2014 GDP growth at 3.7%. He said that despite a contraction in GDP in Q1, growth in domestic demand was slightly stronger than was assumed in the CBI’s May forecast. Lower inventories and stronger imports – particularly services imports – were the main causes of the contraction. The Governor noted that national accounts for the first quarter do not reflect the year as a whole in this respect and should therefore be interpreted with caution.

The big news: regular FX purchases back on the docket

The biggest news in the MPC statement centred on the resumption of the CBI’s suspended programme of regular foreign currency purchases. From now until end-September, the CBI plans to purchase EUR 3m per week in the foreign exchange market. The purchases will take place on Tuesdays, right after the market opens, and if a holiday falls on a Tuesday, the purchases will take place on the business day immediately following. The first purchase under the reinstated programme will take place on Wednesday 18 June 2014. The amount purchased will be re-evaluated in the autumn, or earlier if circumstances warrant it.

nullAt the above-mentioned press conference, the Governor said that, to the extent that this weakens the króna, inflation and interest rates will be accordingly higher. The CBI is therefore using the scope afforded by the summer’s net FX inflows to stockpile foreign currency rather than lower the policy rate. The bank is doing this in response to its assessment of Iceland’s balance of payments problem, which it can mitigate to some extent – in the short run, at least – in this way.

The CBI intends to keep its irregular FX market intervention policy in place; however, we expect the regular purchase programme to reduce or replace any purchases made according to that policy. In light of this, the proposed FX purchase programme does not change our near-term expectations concerning the exchange rate. The ISK has been extremely stable in the recent past, in part because of the CBI’s foreign exchange market intervention, and we expect this to continue. The CBI obviously does not want the ISK to appreciate – at least not in the near future – and today’s announcement underlines the bank’s desire to use this summer’s net FX inflows to expand its non-borrowed reserves rather than allow them to strengthen the ISK. This is a wise move given the small size of the reserves, and it better prepares the bank to address the FX market volatility that could ensue when and if the capital controls are eased to any significant degree. With this in mind, we consider it sensible to use this increased scope to strengthen the reserves rather than cut the policy rate.

MPC tone unchanged

The tone in today’s MPC statement is unchanged from that in May. Committee members still consider it likely that increased near-term growth in domestic demand will probably require further rises in the bank’s real interest rate, other things being equal. If forecasts of rising inflation and a growing output gap in 2015 materialise, such increases in the CBI’s real rate will clearly take place through nominal policy rate hikes.

As we reported in our last policy rate forecast, we expect the MPC to raise the policy rate by 0.75 percentage points in 2015, with the first incremental increase coming early in the year. The uncertainty in this forecast centres on the possibility that the Committee will raise the policy rate sooner. In this context, it is worth remembering that according to the minutes of the MPC’s May meeting, members were of the view that there were grounds for both an unchanged policy rate and a rate hike.