0.25% interest rate cut expected on 4 February
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.
ISK stable since December MPC meeting
Two dissenting votes in December
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.
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.