Unchanged policy rate on 20 August

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 20 August, the next announcement date. In our opinion, the decision will be based on several factors: inflation is at target, the ISK is stable, and the slack in nullthe economy has all but vanished. On the other hand, inflation expectations are broadly unchanged since the last decision date, and long-term expectations are still somewhat above the CBI’s inflation target.

We forecast that the MPC will keep the policy rate unchanged for the remainder of the year. 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. The CBI’s real policy rate is now close to equilibrium after rising markedly this year. We expect inflation to rise somewhat next year, prompting the MPC to respond with nominal rate hikes to bring about an increase in the real rate.

Inflation at target

The consumer price index (CPI) rose 0.17% month-on-month in July, raising twelve-month inflation from 2.2% to 2.4%. Inflation is now the same as it was when the MPC met in June. The inflation outlook for this year is good, and we expect inflation to remain at target for the next nullseveral months after having been below target since February of this year. If our forecast materialises, this year will see the longest period of target-level inflation in a decade. The main reasons for this peaceful interlude are the stability of the ISK, modest domestic cost price increases, and very low foreign inflation.

We expect inflation to begin rising next year, however, as an output gap develops in the domestic economy. We project it to average 3.0% in 2015 and 3.1% in 2016. Our forecast is well in line with the CBI’s most recent forecast, published concurrent with the 21 May policy rate decision. Long-term inflation expectations are still well above the CBI’s target and are broadly unchanged, even though inflation has been below target for several months. The five-year breakeven inflation rate in the bond market was just under 4% right before the MPC’s last meeting and has changed little since then.


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 strengthened slightly last winter. This has played a major role in the recent episode of low and stable inflation. By and large, the CBI appears to be content with the current exchange rate. The ISK has appreciated enough to nullbring inflation back to target. Further appreciation and the associated rise in the real exchange rate would exacerbate Iceland’s balance of payments problem in coming quarters. The CBI has taken advantage of the opportunity afforded by target-level inflation and a relatively advantageous balance of payments in recent months and has bought a sizeable amount of foreign currency to expand its reserves.


CBI could reduce its output growth forecast

nullAccording to the minutes from the MPC’s last meeting, output growth figures for Q1/2014 could indicate that year-2014 growth will be somewhat weaker than in the CBI’s last forecast, published in May. According to that forecast, the CBI expects rather stronger growth than we do. The CBI projects output growth at 3.7%, while we estimate it at 3.2%. 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 CBI will publish an updated macroeconomic forecast on the upcoming interest rate decision date. We expect the bank to adjust its output growth forecast for 2014 and 2015 downwards slightly but to leave its inflation forecast broadly unchanged.


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 main argument in favour of a rate increase discussed at the meeting centred on the benefits of responding swiftly with a rate hike, as the most recent national accounts data suggested even stronger domestic demand than that MPC had thought existed at the previous meeting. Furthermore, long-term inflation expectations are still well above target and have affected very little by positive developments in inflation.

The main argument for unchanged interest rates was that the effects of the rise in the Bank’s real rate had still not emerged in full. In this context, for instance, the long-term real rate in the bond market has risen since the June decision date. It was also pointed out that the level of the Bank’s neutral real rate was still uncertain, in addition to the uncertainty about the size of the output slack and the speed at which it was vanishing. And as is mentioned above, GDP growth figures for Q1 could also indicate that growth for the year as a whole would turn out somewhat weaker than according to the May forecast.


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. In addition, inflation will pick up as 2015 progresses. 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, but we still anticipate a nominal monetary tightening phase beginning early in 2015, with three rate hikes totalling 0.75 percentage points over the course of the year, bringing the policy rate to 6.75% by year-end 2015. We then expect one 0.25-point increase in 2016.


ISK exchange rate the greatest uncertainty factor

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 therefore assumes as well 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 nominal 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.