Policy rate unchanged – against all expectations

The Central Bank (CBI) Monetary Policy Committee (MPC) decided today to keep the bank’s policy interest rate unchanged. This is at odds with our forecast and those of other analysts, all of whom expected a 25-point rate cut. The seven-day collateralised lending rate is therefore unchanged at 5.25%, the overnight lending rate 6.25%, and the rate on seven-day term deposits 4.5%. The CBI considers the last of these to be its key interest rate at present.

Forthcoming wage settlements a determining factor

In this morning’s statement, the MPC says that, because of the highly uncertain labour market outlook coupled with signs of strong GDP growth in the near future, it is appropriate to wait until the economic situation becomes clearer. The Committee is focusing on the outcome of the forthcoming labour market settlements, as the wage demands on the table suggest that negotiations will be difficult and wage expectations from some groups are well above the level consistent with the CBI’s inflation target. 

The MPC assigns greater weight to the wage negotiations than we had expected. We had assumed that, at this stage of the game, the MPC would content itself with warning that excessive pay increases would trigger a policy rate hike. Even though the CBI’s inflation forecast indicates very low near-term inflation, which would otherwise give cause for a rate cut, it is clear that the Committee considers the uncertainty in the forecast to be concentrated on the upside, at least from the standpoint of wages, and the uncertainty great enough to warrant a pause in the monetary easing cycle that began last November and has delivered a combined rate reduction of 0.75 percentage points. 

On the other hand, the Committee states that if pay increases in the upcoming wage settlements are in line with the inflation target and inflation remains below target, the conditions for further nominal rate cuts could develop. Conversely, large pay increases could require that rates be raised again. It therefore appears likely that the MPC will keep the policy rate unchanged on 18 March, its next announcement date, as wage settlements will probably still be pending at that time. Yet it is worth asking – given that the MPC considers the CBI’s real rate relatively high in view of the current business cycle position and near-term outlook – whether it would have been possible to lower the nominal policy rate again now, and then respond to the labour market situation when wage settlements have been finalised.

Does the CBI underforecast inflation?

In the CBI’s most recent Monetary Bulletin, published today, the bank has revised its inflation forecast sharply downwards from its November forecast. This is in line with our expectations – and with room to spare. For instance, the CBI now forecasts average 2015 inflation at 0.7%, which we consider rather unlikely. The bank also projects twelve-month inflation at 1.4% in Q4/2015 and 2.7% in Q4/2016, as opposed to our projections of 2.4% and 2.8%, respectively. The CBI’s recent short-term and medium-term inflation forecasts have generally been too high, but now it seems to us that the reverse is the case and the bank’s forecast is too optimistic. 

GDP growth shifted between years

The CBI has revised its estimate of year-2014 GDP growth downwards since November, from 2.9% to 2.0%, due primarily to the prospect of weaker growth in private consumption and investment than previously projected. On the other hand, the bank has revised its 2015 GDP growth forecast upwards, from 3.5% to 4.2%. The increase in GDP growth this year is due for the most part to exports, which are expected to grow much more strongly than previously forecast (5.3% instead of 2.6%). On the other hand, domestic demand growth (both private consumption and investment) is forecast to be weaker than previously anticipated.

Brighter balance of payments outlook

As a result of the improved outlook for external trade, the CBI is now much more optimistic than before about the current account balance. The bank now forecasts a sizeable underlying current account surplus throughout the forecast horizon: 3.8% of GDP in 2015, followed by 2.1% in 2016 and 2.1% in 2017. The underlying surplus should therefore suffice to cover all estimated unfunded foreign loan payments from borrowers other than the CBI and the Treasury for the next few years. According to the CBI’s Financial Stability report from autumn 2013, these payments will amount to 3.2% of GDP this year, 2.2% in 2016, and 2.3% in 2017. At this morning’s CBI press conference, Deputy Governor Arnór Sighvatsson said that although this is certainly a positive development, maintaining balance of payments stability during the upcoming capital account liberalisation remains the most important consideration.