We forecast an unchanged policy rate on 5 November

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 5 November, the next announcement date. In our opinion, the arguments in favour of an unchanged policy rate will be as follows: even though inflation is below target and the inflation outlook is relatively good and has improved recently, inflation expectations are still above target, and robust near-term growth in domestic demand and mounting tension in the labour marked are likely to generate increased inflationary pressures. 

We forecast that the MPC will keep the policy rate unchanged until the latter half of next year. We expect one 0.25-point increase in 2015, followed by a two-step increase of 0.5 percentage points in 2016. In our opinion, the rate hikes will be implemented in response to growing tension in the economy, with rising inflation and inflationary pressures. 

The inflation outlook has improved since the last CBI forecast 

Inflation now measures 1.9% and has risen by 0.1 percentage points since the CBI’s last interest rate decision date. It has been below the CBI’s 2.5% inflation target since February of this year. We expect inflation to continue to lose pace through the year-end, measuring 1.4% in December. According to our forecast, it will then rise slightly in 2015 but remain close to the inflation target throughout the forecast horizon, which extends until end-2016. If our forecast materialises, it will be the longest period of inflation within the CBI’s tolerance limits (1.0 – 4.0%) since the adoption of the inflation target in March 2001. 

Inflation has been below the CBI’s August forecast in the recent past. At that time, the bank forecast Q3/2014 inflation at 2.3%, whereas the actual measurement was 2.1%. We project inflation for fourth quarter at 1.7%, whereas the CBI forecast it at 2.6%. We also expect it to be somewhat below the CBI’s last forecast in the first half of 2015. The bank’s next inflation forecast, scheduled for publication concurrent with the upcoming policy rate decision on 5 November, is likely to reflect a similar shift, with a downward revision of short-term projections. 

The CBI’s effective real rate in terms of twelve-month inflation now measures 3.4%, or 0.1 percentage points less than at the time of the last policy rate decision. Based on our forecasts of inflation and the policy rate, the real policy rate is expected to rise slightly over the remainder of the year, to 3.8%. It has risen steeply in the past two years and the monetary stance has tightened accordingly, as it was negative by just over 2% by this criterion at the beginning of 2012. It may be that the real policy rate is now close to equilibrium, although the assessment of the equilibrium real policy rate is always somewhat uncertain. However, in terms of inflation expectations, which are still somewhat above target, the monetary stance has not tightened as much over this period. 

CBI holds the ISK steady

In trade-weighted terms, the exchange rate is virtually unchanged since the CBI’s last policy rate meeting. It is obvious that foreign currency inflows have continued, but the CBI has prevented this from strengthening the króna by buying currency in the market. Since the MPC’s last meeting, the bank’s accumulated foreign currency purchases in the domestic foreign exchange market have totalled roughly EUR 48n (approximately ISK 7.3bn), or 42% of FX market turnover, which is roughly equal to its share of total turnover year-to-date. 

The króna has been very stable since May, after appreciating last winter and spring. Exchange rate volatility subsided noticeably after the MPC decided to step up the bank’s intervention in the foreign exchange market in May 2013, for the express purpose of smoothing out swings in the ISK exchange rate. The changes were in line with previous MPC statements emphasising the importance of using monetary policy instruments to promote price stability. 

Solid arguments for a rate cut and an unchanged policy rate

According to the minutes from the MPC’s last meeting, the Committee voted unanimously in favour of the Governor’s proposal to keep the policy rate unchanged. This came as no surprise, as the MPC has voted unanimously in favour of an unchanged policy rate since February of this year. At the February meeting, one member voted against the Governor’s proposal, opting in favour of a 0.25-percentage point rate hike. 

The minutes of the last meeting are milder in tone than the minutes from the meeting before that. According to the most recent minutes, the Committee was of the opinion that there were grounds for keeping interest rates unchanged and for lowering them. This was something new, as a rate cut had last been discussed in March 2014, following a relatively rapid disinflation episode. But the MPC backed away from considering a rate cut at the May meeting, adopting instead a sterner tone and mentioning the possibility of either keeping the policy rate unchanged or raising it. The June meeting followed suit, and in August, the discussion centred entirely on leaving the policy rate unchanged. 

According to the most recent minutes, the main argument in favour of a rate reduction was that the monetary stance had tightened more than previously expected, owing to more rapid disinflation. Furthermore, the outlook for the next few months was for more favourable developments in inflation than had been forecast in August. As a result, the current interest rate level could be too high. The Committee also pointed out that inflation expectations had moved closer to target in the recent term, although members agreed that it was cause for concern that they were still somewhat above target. In view of this, we expect arguments in favour of a rate cut to weigh fairly heavily in the 5 November decision and in the near future.

In a counterweight to this accommodative spirit, the CBI will probably respond as it so often does, by threatening to raise the policy rate if pay rises in the upcoming wage negotiations are out of sync with the inflation target. But that argument will ring a little hollower this time, as inflation is below target and the real policy rate high compared with the current state of the economy. 

We forecast a rate hike in H2/2015

Like the CBI, we expect GDP growth to be strong enough in the near future to generate an output gap. In addition, inflation will gain pace somewhat as 2015 progresses. Both of these factors are grounds for a policy rate hike. We expect the MPC to respond late next year with a 0.25-point increase, bringing the policy rate up to 6.25%. For 2016, we expect the policy rate to rise by another 0.50 percentage points in two increments, a 0.25-point hike in the first half of the year and another in the second half. 

Interest rate spread widens

As before, 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 major 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, thereby eliminating the need for a policy rate hike to provide the needed stability. 

The spread between domestic and foreign interest rates has widened recently, due primarily to low interest rates abroad in an environment of dwindling inflation and a poor economic outlook. If decisive moves are made to lift the capital controls in the near future, it is not certain that there will be a need to widen the spread further to shore up the ISK. The sizeable spread already existing tends to mitigate the risk of a policy rate hike in response to liberalisation.