Interest rate hike in line with forecasts

The Central Bank (CBI) Monetary Policy Committee's (MPC) decision to raise the CBI's policy interest rate by 0.5 percentage points, announced this morning, took no one by surprise; indeed, all official forecasts had projected a rate hike of this amount. As expected, the MPC cited the outlook for wage developments, rising inflation expectations, and signs of robust domestic demand growth as grounds for the increase. 

Wage settlements erode the inflation outlook

According to the MPC statement, even though inflation is low, the inflation outlook has deteriorated markedly since the CBI’s last forecast, published concurrent with the May interest rate decision. The reason for this erosion is the recently landed wage agreements, which provide for larger pay rises than was assumed in the bank’s forecast. Furthermore, the MPC statement mentions that “[i]n order to facilitate the conclusion of wage settlements, the Government has announced measures that will increase public expenditures and reduce tax revenues.” Other things being equal, these measures entail an easing of the fiscal stance. 

Capital account liberalisation could widen the output gap

The MPC considers it important that newly announced capital account liberalisation measures must not be allowed to widen the output gap; that is, they must not lead to the activation of the hitherto sterile component of money holdings. In other words, the Committee considers it important that Treasury revenues be used to reduce debt, not to increase Government spending or ease the fiscal stance. The MPC states clearly that it will monitor developments closely and take appropriate countervailing measures if necessary. 

GDP growth in line with CBI forecast

According to today’s statement, Statistics Iceland’s (SI) newly published Q1/2015 GDP growth figures and the strong recovery of the labour market indicate that economic activity is growing broadly in line with the CBI’s May forecast. That forecast provided for 4.6% GDP growth in 2015 as a whole, driven mainly by investment, consumption, and exports. According to the forecast, an output gap has developed in the economy, after the slack of recent years. 

Signals large rate hike in August 

In this morning’s statement, the MPC signals that a sizeable rate increase is likely in August, followed by further rate hikes in the coming term. According to the MPC, this is necessary in order to ensure price stability over the medium term. At the CBI press conference this morning, the Governor said it was highly unlikely that a rate hike would not be needed in August, but that the size of the increase would depend on near-term wage drift and the degree to which negotiated pay rises were passed through to the price level. 

Based on the MPC statement and the comments made at today’s press conference, it appears very likely that the Committee will raise rates by another 0.5 percentage points on 19 August, the next decision date. After that, three more decision dates remain in 2015 – in September, November, and December – and it is quite possible that the MPC will vote to raise rates still further at that time.