We forecast a policy rate increase on 10 June

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to raise the CBI’s policy interest rate by 0.5 percentage points at its next rate-setting meeting, scheduled for 10 June, citing a poorer inflation outlook, large domestic wage rises, increased inflation expectations, growing tension in the economy, and an increasingly accommodative monetary stance. 

Our forecast is in accordance with the forward guidance found in the MPC’s last statement, published on 13 May, and the minutes from its May meeting. This forward guidance states quite firmly that recent developments in labour market negotiations, together with the rise in inflation expectations and indicators of strong demand growth, suggest that it will be necessary to raise interest rates as soon as the MPC’s next meeting. At the press conference and presentation of the May interest rate decision, the Governor of the Central Bank said that the rate hike could turn out larger rather than smaller. 

Wage settlements out of sync with the inflation target 

In the minutes from the MPC’s last meeting, it is revealed that one Committee member voted against the Governor’s proposal to keep rates unchanged and wanted to raise them by 0.5 percentage points. This member was of the opinion that conditions in the economy already warranted a tighter monetary stance, irrespective of wage agreements, and that it was already obvious that wage agreements would not be in line with the inflation target. This member wanted to raise rates again at the Committee’s next meetings. The four members who voted in favour of the Governor’s proposal to keep rates unchanged were of the view that it did not matter whether interest rates were raised immediately (i.e., in May) or in June, after the labour market outlook had been clarified. Instead, these members focused, among other things, on preparing the market for a rate increase by sending a clear message to this effect. 

In this context, the Committee examined several alternative scenarios showing more rapid wage increases than were included in the CBI’s baseline forecast. According to the minutes, the Committee “considered it clear that even in the alternative scenario involving wage increases in line with what the Confederation of Icelandic Employers (SA) had offered to labour unions, substantial interest rate increases would be necessary, other things being equal, to ensure long-term price stability.” The wage settlements that have now been reached with a large part of the labour market entail slightly larger pay rises than the proposal the MPC had had analysed, which SA had presented at the time of the interest rate decision. Therefore, it is clear that the MPC’s assessment of the wage increases provided for in the newly signed wage agreements will certainly not be milder than this.

The pay increases provided for in the new wage agreements are in line with the projections we made in our most recent macroeconomic and inflation forecast. The combined wage rises are estimated at 8.5% in 2015, 7.5% in 2016, and 6.5% in 2017. The contracts suggest, however, that this year’s increase could turn out slightly larger than we had forecast and next year’s increase slightly smaller. We forecast that inflation, which currently measures 1.6%, will rise above the CBI’s inflation target in Q4/2016 and then average 3.6% in 2016 and 3.7% in 2017, a good percentage point above the target. 

We forecast somewhat higher inflation in the near term than the CBI does in its forecast published concurrent with the 13 May interest rate decision, which projects inflation at 3.0% in 2016 and 3.2% in 2017. The main reason for the difference is that we expect larger pay hikes during the forecast horizon. 

We forecast a 2.5-point policy rate hike from now until end-2017

We expect the MPC to respond to increased inflation, large domestic pay increases, mounting tension in the economy, and a more accommodative monetary stance with further policy rate hikes later this year and in the following two years. We forecast that the MPC will raise the policy rate by a total of 1.0 percentage point this year, 1.0 percentage point next year, and another 0.5 points in 2017. The monetary stance as measured by the difference between the CBI’s effective policy rate and inflation will not tighten much during the period, as inflation is expected to rise strongly during the same period. 

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 policy rate forecast – and our inflation forecast as well. For the short term, there is uncertainty about the legislative bill to be presented before Parliament prior to the 10 June interest rate decision. 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.