Our forecast: unchanged policy rate on 13 May

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 13 May, the next announcement date, having deemed it appropriate to wait with a more decisive move until wage settlements have been reached. Based on the tenor of the current negotiations and the wide gap between the negotiating parties, there is very little chance that agreements will have been reached before 13 May. 

Our forecast is in accordance with the forward guidance found in the MPC’s last statement and the minutes from its last meeting, held in March. The message found there is quite straightforward: mounting unrest in the labour market could derail the stability that has been achieved; therefore, the MPC agreed that it was appropriate to wait until the economic situation became clearer, particularly as regards wage developments. Little has changed in this respect since March; therefore, we expect the MPC to keep this forward guidance unchanged for the present. 

Increased inflation and large pay increases will call for policy rate hikes later in the year

Labour organisations are demanding very large nominal pay increases in the current round of negotiations. If the majority of the contracts provide for these pay hikes, there is the risk of jeopardising the progress made in bringing inflation and inflation expectations back to the CBI’s inflation target, as the CBI’s Chief Economist (a member of the MPC) said in a newspaper article appearing soon after the last interest rate decision date. After a steep drop in H2/2014, inflation expectations have risen in the recent term, owing at least in part to the aforementioned wage demands. For example, the five-year breakeven inflation rate in the bond market has risen from 2.3% at the beginning of the year to 4.1% as of 7 May.  In essence, then, the Chief Economist’s fears have already been realised in part, even though wage settlements are still pending. 

Inflation now measures 1.4%, up from 0.8% at the time of the interest rate decision in March. It has been considerably higher than the CBI projected in its last forecast, which was published concurrent with the MPC’s February interest rate decision, but is still well below the CBI’s 2.5% inflation target. 

We forecast that inflation will rise this year and continue to be much stronger than the CBI projected in its most recent inflation forecast. We expect it to rise above the 2.5 inflation target next year, mainly because of rapid pay rises and continued housing inflation, both of which reflect the growing tension in the economy and labour market. In addition, the base effects from last year’s sharp decline in petrol prices will disappear from twelve-month figures in the latter half of the year. Inflation could prove higher than we have projected, however. Wages could rise more rapidly than we anticipate, house prices could increase more than we expect, and last but certainly not least, the ISK could fluctuate when and if decisive steps are taken to lift the capital controls. 

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 3.1%, as opposed to 3.7% at the time of the interest rate decision date in March. The monetary stance has therefore eased in the interim.

We expect the MPC to respond to increased inflation, large domestic pay increases, mounting tension in the economy, and a more accommodative monetary stance by raising the policy rate 0.75 percentage points this year and another 0.5 points in 2016. In so doing, the MPC will follow through on its statement accompanying the last interest rate decision: “[l]arge pay increases and strong growth in demand could undermine the recently achieved price stability, however, and require that interest rates be raised again.” 

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.