Policy rate unchanged, as forecast

The Central Bank (CBI) Monetary Policy Committee’s (MPC) decision to keep the policy rate unchanged, announced today, was in line with our projections and those of other official forecasters. As regards future rate hikes, the tone in today’s statement was somewhat milder than in the MPC’s August statement. 

Signalling further policy rate rises

Also in line with our forecast, the MPC provides forward guidance suggesting the likelihood of further rate hikes. According to today’s statement, “[i]f inflation rises in the wake of the wage settlements, as forecasts indicate, the MPC will have to raise interest rates still further in order to bring inflation back to target over the medium term.” 
In spite of this, we expect the policy rate to be held unchanged until mid-2016 and then be raised by 50 basis points in the latter half of the year. In addition, the adjustment of the effective policy rate towards the centre of the interest rate corridor once liquidity diminishes with the stability contribution and the offshore ISK auction will probably constitute the equivalent of a roughly 75-point rate hike, which we expect in the first half of 2016. 

ISK appreciation slows the tightening phase

According to the MPC, a “stronger króna and global price developments have provided the scope to raise interest rates slightly more slowly than was previously considered necessary, but they do not change the need for a tighter monetary stance in the near future.” As could be expected, the MPC notes that H1/2015 GDP growth turned out well above the CBI forecast and that the outlook is for “continued robust GDP growth and a widening positive output gap in the coming term.” The Committee goes on to say that the short-term inflation outlook has improved, in part because of the appreciation of the ISK, but that the medium-term outlook is broadly unchanged. 

The big news: increased reserve requirements

The most newsworthy part of this morning’s statement is the MPC’s decision to increase reserve requirements from 2% to 4% “to strengthen the Bank’s liquidity management in the wake of its substantial foreign currency purchases in the recent term and in connection with the winding-up of the failed banks’ estates and the planned auction to release or tie up offshore krónur.” 

The reserve requirement for the current reserve maintenance period (21 September – 20 October) is ISK 31.1bn, and the change will take effect as of the maintenance period beginning on 21 October. Based on the total for the current period, the amount of the imposed reserve requirement can be expected to double to just over ISK 60bn. At this morning’s press conference, the Governor said that the MPC’s decision is not conceived as a means of affecting the monetary stance but as a temporary measure designed in part to ensure that monetary policy is implemented as it should be. In our opinion, though, the change in reserve requirements will have some tightening effect, although it is difficult to pinpoint how strong that effect will be. 

Dissatisfied with fiscal easing

According to the MPC, the cyclically adjusted Treasury outcome for this year and the budget proposal for next year entail a relaxation of fiscal policy. At today’s press conference, the Governor said that the fiscal easing was equivalent to about 1.5% of GDP and that, other things being equal, it would call for a tighter monetary stance. 

Offshore ISK auction just before or after the New Year

According to the Governor, preparations for the auction of offshore ISK proposed for October or November are in full swing, and the auction will take place relatively close to the proposed time period, either just before or just after the turn of the year. The Governor said it would be inappropriate to hold the auction concurrent with the settlement of the failed banks’ estates, as both would affect liquidity in circulation and it was necessary to keep the two separate. As regards the estates, the settlement process and its impact on the financial system and individual financial institutions would probably be clarified in October. 

No exchange rate peg

Arnór Sighvatsson, Deputy Governor of the CBI, said at today’s press conference that the CBI’s recent foreign currency purchases were to an extent a response to carry trade-related inflows in the recent term. However, they were due primarily to a sizeable trade surplus. He said as well that the recent appreciation of the ISK did not represent a change in CBI policy and that the bank was not prepared to declare a pegged exchange rate; i.e., the bank was not altogether disconnecting market forces in the FX market. The recent ISK appreciation was a sign of heavier FX inflows and had taken place in spite of substantial FX purchases by the CBI. How much the Central Bank should lean against exchange rate movements stemming from the real economy was an important question. After the recent appreciation, the real exchange rate was below its long-term average.