Our forecast: unchanged policy rate on 18 March

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 18 March, the next announcement date. We think it likely that the Committee consider it appropriate to wait until the lines are drawn more clearly as regards wages – in particular, to wait until the current private sector wage negotiations have been concluded. It is all but impossible that the contracting parties will have landed an agreement in advance of the upcoming policy rate date. We expect the MPC to take account of the risk that labour market unrest could derail the recently achieved price stability. 

Our forecast is in accordance with the forward guidance found in the MPC’s last statement and the minutes from its last meeting, which suggests strongly that the Committee is likely to keep rates unchanged for the present. A noteworthy statement in the minutes is this one:

 “The spare capacity in the economy had more or less disappeared, and robust GDP growth was expected in the near future. Wage growth had been strong in Iceland, unlike in most trading partner countries, and mounting unrest in the domestic labour market could jeopardise the stability that had been achieved. For this reason, the Committee agreed that it was appropriate to wait until the economic situation became clearer, particularly as regards wage developments.” 

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 more rapidly this year than the CBI projects in its most recent inflation forecast. The real policy rate will then decline at a time when an output gap is developing in the domestic economy. We expect the MPC to respond to rising inflation, a growing output gap, and an increasingly accommodative monetary stance by raising the policy rate by 0.75 percentage points in 2016. 

Inflation to gather pace as the year progresses 

Inflation now measures 0.8% and is unchanged since the February 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. 

For the near term, the outlook is for inflation to rise somewhat in excess of the CBI’s February forecast. We expect inflation to rise in the near future and slightly exceed the CBI’s inflation target in 2016. Our forecast and the CBI’s are alike in some respects, however. For instance, we both expect inflation to gain momentum this year and then settle close to target next year. The difference is, though, that the CBI expects this to happen more slowly and to a lesser degree than we do. According to the last minutes, the MPC considers the uncertainty in the CBI’s inflation forecast to be tilted to the upside. 

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% and is therefore unchanged since the February interest rate decision. It has declined since November, however, when it measured 4.0%. Until then it had risen sharply since the beginning of 2012, when it was negative. 

According to the February minutes, MPC members agreed that the CBI’s real rate was rather high in view of the business cycle position. Based on our forecast of an unchanged policy rate until next year and a rise in inflation later this year, the real policy rate can be expected to continue falling until early 2016, bottoming out at 1.6%. This would 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. The CBI forecasts GDP growth at 4.2% in 2015 and 2.8% in 2016. We therefore assume that the MPC will respond by raising the policy rate by 0.75 percentage points in 2016, causing the real rate to rise to 2.4% by the end of the year. 

2014 GDP growth in line with CBI forecast

According to Statistics Iceland’s (SI) newly published preliminary figures, GDP grew by 1.9% in 2014, well above the 0.5% growth rate indicated by the 9M preliminary figures. It is also in line with both our expectations and the CBI’s February forecast. As a result, the new figures should not change the bank’s assessment of the economy, nor should it affect the MPC’s upcoming interest rate decision. Year-2014 GDP growth was close to equilibrium, and by several measures the economy was near equilibrium during the year. 

MPC unanimously in favour of unchanged policy rate

According to the minutes of the MPC’s February meeting, members voted unanimously to keep the policy rate unchanged on 4 February. This is the first time since last October that the Committee has been in full agreement. 

Growing concern about wage settlement risk

The minutes of the MPC’s last meeting indicate that members’ concerns about upcoming wage agreements had escalated since the December meeting. Members were convinced that the contracts negotiated since the December meeting and indications that recent agreements would affect wage demands in the near future had reduced the likelihood of relatively moderate three-year agreements. 

According to the minutes, members believed that, if inflation remains below target and pay increases in upcoming wage settlements are consistent with the inflation target, conditions for further reductions in nominal interest rates could develop, other things being equal. On the other hand, they were of the opinion that large pay increases and strong growth in demand could undermine the recently achieved price stability and require that interest rates be raised again. These statements make it clear that the outcome of the wage negotiations will be a major factor in subsequent monetary policy decisions. Until then, however, it appears that the MPC will keep rates unchanged.

Included in the CBI’s inflation forecast, as in our own, is a projection of wage developments during the forecast horizon. We expect wages to rise by 6.6% this year and 6.5% next year. 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 wage settlements and proposed capital account liberalisation

As before, the future path of the exchange rate is difficult to predict, in view of the uncertainty about the settlement of the failed banks’ estates and the anticipated relaxation 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.