Our forecast: unchanged policy rate on 30 September

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 30 September, the next announcement date. In our opinion, the Committee will support its decision by citing the marked improvement in the inflation outlook since the last meeting, owing to the appreciation of the ISK and other factors. Offsetting this, however, are robust output growth, substantial underlying cost price inflation, and a more relaxed fiscal stance in 2016 than in 2015, according to the budget proposal for next year. 
Our forecast is in accordance with the forward guidance found in the MPC’s last statement and the minutes from its last meeting. Two rate-setting dates remain after the September meeting, and we do not expect the MPC to decide to raise rates further on those occasions. 

Vastly improved inflation outlook concurrent with ISK appreciation

The near-term inflation outlook has improved greatly, in line with the recent appreciation of the ISK. Furthermore, global oil and commodity prices have fallen, and the abolition of import duties on clothing and footwear at the turn of the year could contain inflation temporarily. According to our most recent inflation forecast, published on 10 September, inflation will rise in the near term, but not as much as previously projected. It will rise above the CBI’s 2.5% inflation target before the year-end but remain close to target through mid-2016. It will rise rapidly thereafter but remain below 4.0%, the upper deviation threshold of the target, in 2017. 

In our opinion, the inflation outlook is much more favourable than that described in the CBI’s last inflation forecast, published concurrent with the August policy rate decision. In our view, that forecast was too pessimistic about the impact of wage agreements on near-term inflation, and furthermore, developments in the ISK exchange rate have diverged greatly from the CBI forecast. The bank’s forecast is based on the assumption that the trade-weighted exchange rate index (TWI) will hold unchanged at about 205.4 points throughout the forecast horizon. Now, however, the TWI sits at 194.5 and the ISK is about 5.6% stronger than the CBI specified in its forecast. This has considerable impact on inflation because of the large proportion of directly or indirectly imported goods in the consumer basket. 

Strong GDP growth in H1/2015

Preliminary figures published by Statistics Iceland (SI) on 11 September showed strong output growth in the first half of the year. According to these figures, GDP growth measured 5.2%, the strongest first-half results since 2007. It is also well above the Central Bank’s (CBI) most recent forecast of 4.2% for 2015 as a whole, published concurrent with the August interest rate decision. The difference between the preliminary figures and the CBI forecast lies mainly in robust export growth in the first half. Clearly, the MPC will take account of this when it meets next week to set the bank’s policy interest rate. Indeed, one of the Committee’s arguments in favour of its recent rate hikes has been the development of an output gap after the slack prevailing in recent years. 

Fiscal stance easing

The fiscal budget proposal presented before Parliament on 7 September indicates that the overall and primary balances will improve between 2015 and 2016. It is assumed that the primary surplus excluding irregular items will increase from 3.7% of GDP in 2015 to 4.1% in 2016. On the other hand, the output gap will grow at the same time. The CBI’s macroeconomic forecast projects the output gap at 0.9% of potential output in 2016, as opposed to 0.0% this year. According to this, the budget proposal seems to entail a relaxation of the fiscal stance between years. It appears, then, that the same old story will repeat itself once again: fiscal policy will be out of sync with monetary policy – or at least out of sync with the fiscal stance that the Monetary Policy Committee would like to see. It can be assumed that the MPC will consider these factors when it sets the policy rate next week. 

Tone milder in August

The most striking feature of the MPC’s last statement was the marked softening in the tone concerning upcoming monetary policy decisions. The forward guidance, which before the decision had leaned unequivocally towards a rate hike, was less emphatic in that direction. 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”. The August statement was less stern: “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 was not convinced beyond doubt that inflation would rise as quickly as was assumed in the CBI’s inflation forecast, published concurrent with the August interest rate decision, and that this was 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.” This is a new twist from the MPC, and it is important that these “other policy instruments” be identified and the timing and method of their potential application be made known as well. One possibility is monetary tightening that moves the effective policy rate closer to the centre of the interest rate corridor – for instance, following the winding-up of the failed banks’ estates. 

One member voted for a 0.75-point rate hike

At the MPC’s last meeting, the Governor proposed that the policy rate be raised by 0.5 percentage points. According to the minutes from that meeting, all members voted in favour of the proposal except for one dissenter, who voted for a rate increase of 0.75 percentage points.

The results of the voting came as no surprise. At the June meeting, one member voted against the Governor’s proposal of a 0.5-point rate hike, preferring instead to raise rates by a full percentage point. Another member would have preferred to raise rates by 0.75 percentage points in June but was nonetheless willing to vote in favour of the Governor’s proposal. It appears, then, that there was a slightly stronger consensus in August than in June, in addition to the milder tone from the Committee. 

We expect a rate hike in 2016 

We expect the MPC to respond to increased inflation, mounting tension in the economy, and a more accommodative monetary stance with further policy rate hikes next year. We expect 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 krónur exit 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. 

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. 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. The capital account liberalisation strategy, part of which was introduced this past June, supports this assumption of ours, as it places emphasis on mitigating exchange rate volatility and minimising the risk of a balance of payments shock as the liberalisation process moves forward.