Policy rate hike in line with forecasts

Today’s decision by the Central Bank (CBI) Monetary Policy Committee’s (MPC) to raise the policy rate by 0.5 percentage points was in line with our forecast and the forecasts published by other domestic market analysts. As grounds for the rate hike, the MPC cited the deterioration in the inflation outlook since the CBI’s May forecast, which is due to negotiated wage rises in excess of that forecast. The CBI also expects the output gap to widen in the coming term. The bank’s key interest rate (the rate on seven-day term deposits) is now 5.5% and has risen by a percentage point since the beginning of June. 

Milder tone

The big news in today’s MPC statement is that the tone is milder as regards monetary tightening further ahead, and the forward guidance provided – which until today was strongly in the direction of a rate hike – is now less unequivocal on this point. For example, the MPC’s June statement said that “it seems apparent that a sizeable rate increase will be necessary in August, followed by further rate hikes in the coming term”. Today’s statement is milder: “If inflation rises in the wake of the wage settlements, as is forecast, the MPC will have to raise interest rates still further in order to bring inflation back to target over the medium term.” This implies that the Committee is not convinced beyond doubt that inflation will rise as quickly as is assumed in the CBI’s inflation forecast, published concurrent with this morning’s interest rate decision, and that this is the reason for the less aggressive tone. 

The MPC has also added this sentence to its statement: “In addition, the interest rate path will depend on whether other policy instruments are used to contain demand-side pressures in the coming term.” Governor Már Guðmundsson explained this at this morning’s press conference. He mentioned the interplay between fiscal policy and monetary policy, for instance, and said that tighter fiscal policy entailed less need for increased monetary tightening. Presumably this is a reference to the allocation of the capital that will revert directly or indirectly to the State when the failed banks’ composition agreements are finalised or a stability tax is levied on the estates. Már also mentioned the possibility that macroprudential policy instruments might be applied in the near term. These policy instruments could be applied in stages, as the capital controls are gradually lifted and Iceland’s future monetary and exchange rate framework is clarified. According to Már, restrictions on capital inflows would be the next step and could be implemented in the next few months. This would probably entail some sort of short-term reserve requirement, which would mitigate the impact of interest rate differentials on the exchange rate, thereby shifting the influence exerted by monetary policy from the exchange rate to market interest rates. 

Higher inflation and weaker output growth

As expected, the inflation forecast appearing in today’s issue of Monetary Bulletin is considerably more pessimistic than the forecast published in May. The Bank now forecasts that inflation will rise to 4.0% early in 2016 and then lie in the 4.0-4.5% range for about two years before tapering off again, whereas the May forecast provided for an inflation rate of 3.0% in 2016 and 3.2% in 2017. The change is due mainly to the massive pay hikes provided for in the recent wage agreements, which are offset to an extent by a minor appreciation of the króna, favourable developments in terms of trade, weaker output growth, and a tighter monetary stance. The CBI estimates that nominal wages will increase by just over 10% this year, just over 8% next year, and about 6% in 2017. 

The CBI now forecasts weaker near-term output growth than it did in May. It projects the growth rate at 4.2% in 2015 (as opposed to 4.6% in May), 3.0% in 2016 (3.4%), and 2.8% in 2017 (3.1%). The downward adjustment of the output growth forecast is due to weaker growth in investment and exports coupled with more rapid growth in imports; however, the CBI expects stronger private consumption growth as well. The composition of output growth is therefore less favourable in the new forecast than in the previous one, and growth in labour demand is weaker. 

The market response to today’s interest rate decision has been rather muted thus far. Yields on nominal Treasury bonds have fallen, however, which indicates that the softer tone in the MPC statement has reduced expectations of a large policy rate hike in the near future. As of this writing (11:00 hrs.), Treasury bond yields have fallen by 2-11 points in fairly brisk trading. There has been no trading as yet with indexed benchmark bonds, however.