We forecast a 0.5-point policy rate hike on 19 August
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 19 August, citing a poorer inflation outlook, large domestic wage rises, and growing tension in the economy.
MPC unanimous on need for substantial rate hike in August
According to the minutes of the Central Bank (CBI) Monetary Policy Committee’s (MPC) last meeting, held on 8 and 9 June, four of the five members voted in favour of the Governor’s proposal to raise the CBI’s policy rate by 0.5 percentage points. One of the four would have preferred to raise rates by 0.75 percentage points but was nonetheless willing to vote in favour of the Governor’s proposal. One member voted against the Governor’s proposal, however, voting instead to raise interest rates by 1 percentage point.
The voting pattern reflects the sterner tone of the statement accompanying the MPC’s May interest rate decision. The minutes make it clear that Committee members wanted the MPC statement to send an unambiguous message that further rate hikes were ahead. According to the minutes, MPC members agreed that “it seemed apparent that a sizeable rate increase would be necessary in August, followed by further rate hikes in the coming term, so as to ensure price stability over the medium term.” As is stated in the minutes, “explicitly signalling upcoming rate hikes would prepare the market for them. To an extent, the effects of the announced interest rate increases would surface immediately” in the bond market, as was the case in May. This more stringent tone therefore tends to tighten the monetary stance in excess of the actual 0.5-point rate hike.
We expect the CBI to revise its inflation forecast upwards
The CBI is scheduled to publish its updated inflation forecast concurrent with the August interest rate decision. The last forecast was published on the date of the May decision. We expect the bank to revise its inflation forecast upwards, in part due to recent wage settlements. We expect inflation to be somewhat higher in the coming term than the CBI assumed in its May forecast, which put inflation at 2.7% in Q4/2015 and 3.3% in Q4/2016. Our own forecast is for 3.1% and 3.8% inflation, respectively, in the fourth quarter of 2015 and 2016. The main reason for the difference is that we expect larger pay hikes during the forecast horizon than the CBI does.
On the other hand, the breakeven inflation rate as measured in terms of the spread between indexed and nominal bond interest rates has declined since the CBI’s last interest rate decision. The five-year spread was 4.6% at the time of the MPC’s June meeting and is now 4.2%. In this context, the MPC will doubtless consider the fact that the decline is due, in large part at least, to the entry of non-residents into the bond market during the period. This in turn is attributable to planned capital account liberalisation and to the changed outlook for the supply of nominal Treasury bonds in the near term. Furthermore, by the time of the next meeting, the Committee will have in hand the results of the CBI’s most recent survey of market agents’ inflation expectations. The last such survey was carried out in May, prior to the publication of the bank’s macroeconomic and inflation forecast.
We forecast a 1.5-point policy rate hike from now until end-2016
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 this year and next year. We forecast that the MPC will raise the policy rate by a total of 1.0 percentage point this year, including the projected 0.5-point hike in August, followed by a 0.5-point increase in 2016. In addition, the monetary stance will presumably tighten when the CBI’s effective policy rate moves closer to the centre of the interest rate corridor. The reason for this is that the banks’ funding will shift increasingly to short-term borrowing from the CBI as the failed banks’ estates are settled and offshore ISK are released from the economy. The MPC will take account of this when it formulates monetary policy, as increased interbank market rates deriving from these changes, plus the derived upward effects across the yield curve, are the equivalent of a policy rate hike. This change will have an impact equivalent to a 0.75-point rate increase. In spite of these increases, 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.