0.25% interest rate cut expected on 4 February

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 4 February. We expect the Committee to base the decision on the CBI’s forthoming inflation forecast, which will doubtless indicate that inflation will be well below the level assumed in the bank’s November forecast – and below the CBI’s inflation target – well into 2016. Inflation has now been below target for a full year, even falling below the lower tolerance limit in December. In response to the current wage settlement risk – i.e., the risk that upcoming wage negotiations will result in pay rises out of sync with the inflation target – we expect the MPC to content itself with taking a cautionary stance and explaining that such an outcome would call for rate hikes. 

We expect the rate cut in February to conclude the monetary easing phase begun in November. Thereafter, we expect the MPC to hold policy rate unchanged through this year. If the aforementioned wage settlement risk materialises, however, it can be assumed that the MPC will respond with a rate hike. If our forecast is borne out, inflation will rise this year, and the real policy rate will taper off as the domestic economy gains traction. We expect the MPC to respond to rising inflation, a growing output gap, and an increasingly accommodative monetary stance with a one-point policy rate hike in 2016. 

Inflation below target through 2015 and beyond 

Inflation now measures 0.8%, as opposed to 1.0% in December, when the MPC announced its last interest rate decision. Low global inflation and a stable ISK are the main reasons for this low inflation rate in spite of the hefty wage increases negotiated in the domestic labour market last year. Underlying inflation as measured by core index 3 has been on the decline, falling from 2.8% last August to 1.4% in January. In the CBI’s opinion, low underlying inflation indicates that the current disinflation episode is relatively broad-based. 

Inflation has been well below the CBI’s last inflation forecast, which was published concurrent with the November policy rate decision. It measured 1.2% in Q4/2014, for instance, whereas the bank had forecast 1.7%. In addition, the inflation outlook is now much better than that presented in the CBI’s November forecast. According to our forecast, inflation will average 0.8% in Q1/2015, whereas the CBI’s November forecast assumed 2.0%. In general, our forecast for inflation in 2015 is 1.2 percentage points below the CBI’s. We assume that the CBI’s new inflation forecast, scheduled for publication on the interest rate decision date, 4 February, will reflect the improved inflation outlook and will be close to our own. 

In terms of twelve-month inflation and the CBI’s key interest rate – the rate on seven-day term deposits – the CBI’s real rate is now 3.7%, after declining 0.3 percentage points since the December interest rate decision date. The 0.5-point nominal rate cut in December did not lower the real policy rate because inflation fell during the same period. The real policy rate is now beginning to fall, after rising sharply in the recent past. According to the minutes of the MPC’s December meeting, members agreed that, in spite of the nominal rate reduction in November, the Bank’s real rate was higher than was warranted by the business cycle position and the near-term outlook. Based on our inflation and policy rate forecasts, it can be expected that the CBI’s real rate will continue to decline until early next year, supported by a nominal rate cut in February and rising inflation over the course of this year, to about 1.7% at the beginning of 2016. If this materialises, it will put the real rate below equilibrium and will have a stimulative effect, and it will occur alongside a growing output gap and rising inflation, as is mentioned above. We therefore assume that the MPC will respond by raising the policy rate by a percentage point in 2016, causing the real rate to rise to 2.4% by the end of the year. 

ISK stable since December MPC meeting

In trade-weighted terms, the exchange rate is virtually unchanged since the CBI’s policy rate meeting in December. 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 76m (approximately ISK 11.7bn), or 42% of FX market turnover, which is on a par with its share of total turnover in 2014. 

Two dissenting votes in December

At the MPC’s December meeting, three members voted in favour of the Governor’s proposal to lower the policy rate by 0.5 percentage points, but two voted against it, voting instead for a rate cut of 0.25 percentage points. 

According to the minutes of the meeting, the main argument in favour of the smaller reduction was that inflation was likely to rise again in the long run, driven by pressures from the labour market and the diminishing slack in the economy. Even though inflation expectations were at target and the opportunity to lower rates had finally presented itself, they had only recently fallen to target; therefore, it was not entirely certain that they were firmly anchored there. The risk was that inflation would rise rapidly once the conditions that had contained it no longer existed. It would therefore be appropriate to wait with a larger reduction until major wage settlements had been finalised. 

It was also pointed out in the minutes that most indicators of domestic demand suggested that growth was much stronger than was implied by the national accounts. In this context, it will be interesting to see the CBI’s new macroeconomic forecast on 4 February. We expect that the CBI will lower its estimate of 2014 GDP growth and that its estimate of the current level of output gap will reflect this. 

Another point mentioned was the uncertainty about whether the effects of lower petrol prices, which had contributed temporarily to disinflation, would last; furthermore, the unrest in the labour market indicated the continued presence of a significant risk that inflation would rise above target again. As a result, it was more advisable to lower the policy rate in smaller increments until the situation grew clearer.

Excessive pay increases will trigger rate hikes

There are still no signs of excess demand in the labour market, although the slack in the economy is more or less absorbed and forecasters expect an output gap to develop in coming months. The current conflict in the labour market centres on relative wages and could occur at any inflation rate, to paraphrase the MPC minutes from December. The minutes go on to say that at this stage, it would be appropriate to respond to the risk of excessive pay rises that would jeopardise the inflation target by explaining in detail that such a development would call for interest rate increases. 

Included in the CBI’s inflation forecast, as in our own, will be a projection of wage developments during the forecast horizon. We expect wages to rise by 6.6% in 2015 and 6.5% in 2016, as wages have risen by 6.6% in the past twelve months according to the Statistics Iceland (SI) wage index. This wage forecast underlies our policy rate forecast. Our wage forecast includes our projections regarding the upcoming labour market settlements and our estimates of wage drift. If wages rise more than this, it will require that we revise our policy rate forecast upwards. 

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 one of the chief uncertainties in our long-term policy rate forecast – and our inflation forecasts as well. In the short run, the greatest uncertainty is the outcome of wage negotiations. 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.