We forecast a 25-point rate cut on 10 December

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to lower the CBI’s policy interest rate by 0.25 percentage points at its next rate-setting meeting, scheduled for 10 December. We expect the grounds for the rate reduction to be that the CBI’s real rate has risen more than expected in the recent term and that the monetary stance has tightened rather than easing since the November rate cut. The recent increase in the real rate has been greater than is warranted by the business cycle position and the near-term outlook. The short-term inflation outlook has also improved somewhat more than was assumed in the CBI’s most recent inflation forecast. In addition, inflation expectations have fallen still further since the last MPC meeting and are now close to target – short-term expectations in particular. 

Another 0.25% rate cut expected on 4 February

The next rate-setting meeting after the one on 10 December is scheduled for 4 February 2015, at which time the CBI will publish its updated macroeconomic and inflation forecast. We expect the improved short-term inflation outlook to be reflected in that forecast. Inflation will be low at that time – about 1.0%, according to our forecast – and inflation expectations can be expected to have fallen still further. However, it is unlikely that private sector wage negotiations will be complete by then. We anticipate that, in view of these points, the MPC will decide to lower the policy rate by another 0.25 percentage points at its February meeting, bringing the CBI’s collateralised lending rate to 5.25%, following a three-increment reduction of 0.75 percentage points since November. 

If early-2015 wage settlements are in line with the CBI’s inflation target, a further 0.25-point rate cut is possible on 18 March. Given the tenor of the discussions in the labour market, however, we consider this less likely than the alternative – i.e., that pay rises will be larger than the MPC will consider consistent with a policy rate reduction. As a result, we forecast that the policy rate will remain unchanged in March, bringing to an end the short monetary easing phase that began in November. 

Monetary tightening to resume late 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 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, presumably in November, bringing the policy rate up to 5.50%. For 2016, we project a rate increase of 1 percentage point in several increments. 

Inflation below CBI forecast for the short term 

Inflation now measures 1.0% and has fallen by 0.9 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. According to our most recent preliminary forecast, it will taper off slightly in December, to 0.7%. We expect it to rise slightly in 2015 but remain close to the inflation target throughout the forecast horizon, which extends until end-2016. 

According to our preliminary forecast for December, inflation will average 1.2% in Q4 and 1.1% in Q1/2015. The CBI’s most recent macroeconomic and inflation forecast, published concurrent with the last policy rate decision, estimated Q4 inflation at 1.7% and Q1/2015 inflation at 2.0%. The near-term outlook is therefore much brighter than the CBI had projected, in terms of both published statistics and our own forecast. We expect this to be reflected in the bank’s new inflation forecast, which will be published concurrent with the first policy rate decision of the new year, on 4 February 2015. 

In terms of annual inflation, the CBI’s real rate is now just under 4.0% and has risen by nearly 0.7 percentage points since the last policy rate decision, even in spite of the rate cut implemented then. 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 4.1%. It has risen steeply in the past two years, as it was negative by just over 2% by this criterion at the beginning of 2012, and the monetary stance has tightened accordingly. It may be that the real policy rate is now somewhat above equilibrium, although the assessment of the equilibrium real policy rate is always uncertain. 

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 39bn (approximately ISK 6.0bn), or 38% of FX market turnover, which is roughly equal to its share of total turnover year-to-date. 

MPC minutes: one member voted against; another would have preferred to wait

One of the five members of the Central Bank (CBI) Monetary Policy Committee (MPC) voted against the Governor’s proposal to lower the policy rate at the MPC’s last meeting, held in advance of the 5 November policy rate decision date. Instead, this member voted to keep the policy rate unchanged. Of the four members who voted in favour of the Governor’s proposed reduction, one of them would have preferred to keep rates unchanged at this time and wait until December with a rate cut. This was revealed in the minutes from the MPC meeting. 

The dissenter on the Committee said, among other things, that the interest rate decision should take account of the expectation that, further ahead, inflation would rise again because of inflationary pressures from the labour market and the diminishing slack in the economy. This member also noted that the uncertainty about the inflation outlook was somewhat concentrated on the upside. 

The member who voted in favour of the rate cut but would have preferred to postpone it until December was also concerned about the unrest in the labour market. Furthermore, this member would have preferred to wait until the effects of the Government’s debt relief package on demand were known. It is now clear that shifting the debt relief measures forward in time will somewhat increase the impact on demand and inflation, which may affect the December policy rate decision. 

According to the minutes, there were grounds for a reduction and for keeping the policy rate unchanged. As at the last MPC meeting, held at the end of September, the main argument in favour of lowering interest rates was that the monetary stance had tightened more than previously expected. The CBI’s nominal interest rates had been unchanged for two years, but its real rate had risen more than previously anticipated, owing to more rapid declines in inflation and inflation expectations than were warranted by the business cycle position and the near-term outlook. 

Labour market in the cross-hairs

According to the minutes, the MPC considered the scope for pay increases in upcoming wage settlements to be limited by the slow rate of productivity growth. The Committee considered this an argument in favour of an unchanged policy rate; i.e., that it would be wise to wait until major wage settlements had been finalised, particularly in view of the time lags in monetary policy transmission. 

According to figures from Statistics Iceland (SI), total hours worked were up 1.0% year-on-year in October, a statistic that the MPC considers in its interest rate decisions. Labour demand growth has lost pace in the recent term and is weak at present. For example, total hours worked rose 0.6% in Q3, as opposed to 2.7% in Q2 and 3.0% in Q1. So far this year, the pace of the labour market recovery has been somewhat below CBI forecasts. 

In this context, it will be interesting to see SI’s third-quarter GDP figures, scheduled for publication on 5 December. The MPC will consider these figures in its December interest rate decision. Both we and the CBI expect relatively strong GDP growth during the quarter. If our forecasts materialise, the figures will indicate some labour productivity growth during the period. 

Uncertainty about proposed capital account liberalisation

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. 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.