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We forecast an unchanged policy rate on 4 November

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to hold the policy rate unchanged on 4 November, the next announcement date, citing the marked improvement in the near-term inflation outlook and the scope available to respond to growing domestic inflationary pressures once the magnitude of those pressures has grown clearer. 

As in the recent past, however, the Committee will stress the need for monetary tightening as tension mounts in the economy and the effects of imported deflation taper off. We expect this message from the MPC to be followed by a 1.5 percentage point rise in the effective policy rate over the course of 2016. Of that amount, we expect half to take the form of nominal rate hikes and the other half to come from a shift in effective interest rates from the floor of the interest rate corridor to the centre, in response to reduced financial system liquidity. 

Improved short-term inflation outlook in the wake of ISK appreciation

The short-term inflation outlook has improved noticeably since the Central Bank’s August forecast, which provided for rapidly rising inflation in the latter half of the year and headline inflation above 4%, the upper deviation limit of the inflation target, throughout 2016. The main reason for the improvement is the more than 6% appreciation of the króna since August, coupled with lower global oil and commodity prices. Furthermore, the CBI’s August forecast – of a year-on-year rise in wage costs averaging over 10% – appears to have been more pessimistic about 2015 wage developments than was warranted. In comparison, by the same measure, we anticipate a rise in wages of approximately 7%, which accords well with Statistics Iceland (SI) figures for the first nine months of the year. 

According to our most recent inflation forecast, inflation will measure 2.2% in Q4/2015 (as opposed to 3.8% in the CBI’s August forecast) and 3.4% in Q4/2016 (CBI forecast 4.2%). Assuming that the CBI views recent developments much as we do, it can be assumed that the bank’s new forecast will put inflation closer to the 2.5% target, at least well into next year. This implies as well that short-term real rates will be commensurably higher by most measures in the near term. 

Although inflation has been below the CBI’s inflation target for nearly a year and a half, the current inflation rate reflects divergent developments of the main underlying factors. Robust domestic inflation and imported deflation pull in opposite directions. In September, for instance, domestic inflation excluding housing measured 3.8%, whereas there was 3.4% deflation on imported goods at the same time. Presumably, the impact of this imported deflation will drop out of CPI measurements over time – unless the ISK appreciates materially – whereas the domestic factors will grow stronger. As a result, there is greater agreement between our forecasts and the CBI’s most recent forecasts further out the forecast horizon, and the CBI’s new forecast will probably be along the same lines. 
 

Financial conditions to return to normality

An unusual set of circumstances in the capital market has somewhat complicated the transmission of the policy rate along the yield curve in the recent term. In spite of rate hikes totalling 1 percentage point since the beginning of May, long-term market rates have fallen sharply, mostly due to the entry of new foreign investors into the bond market. By now, the yield on 10-year Treasury bonds is somewhat below the effective policy rate, and the rate hikes are therefore not being transmitted to long-term rates at present. The MPC discussed this in particular at its last rate-setting meeting and is faced with devising ways to narrow the effective interest rate spread vis-à-vis foreign investors by imposing some sort of controls on capital inflows. Unremunerated reserve requirements have been mentioned in this context. In our opinion, it is unlikely that such policy actions will see the light of day before well into 2016, but if they are implemented, monetary policy transmission could normalise once again. Sometime next year, this, together with reduced financial system liquidity following the levy of the stability contribution and the release of offshore krónur, will probably lead to a higher general interest rate level for a given policy rate. 

Outlook for stronger GDP growth and easier fiscal stance

At its last interest rate decision (end-September), the MPC was of the view that growth in economic activity was in line with the CBI’s August forecast, although H1 GDP growth had turned out somewhat stronger than projected. The most recent indicators of private consumption – payment card turnover, new motor vehicle registrations, and overseas travel – indicate robust growth in Q3. For the year as a whole, private consumption growth may somewhat exceed the 4.2% forecast by the CBI in August, however; according to our recent macroeconomic forecast, we expect 4.8% growth this year in this largest component of GDP. 

Furthermore, in the next issue of the CBI’s Monetary Bulletin, to be published concurrent with the 4 November interest rate decision, we expect the CBI to revise its 2016 GDP growth forecast upwards, mainly because of stronger business investment. According to our forecast, GDP growth will measure 4.3% this year and 4.4% next year, as opposed to 4.2% and 3.0%, respectively, in the CBI’s August forecast. It is likely that the CBI’s new forecast will provide for stronger GDP growth in 2015 and 2016 combined – and therefore a wider output gap – than the August forecast did. 

In addition to this, it is worth noting that at the time of the last interest rate decision, the MPC was of the opinion that the 2016 fiscal budget proposal and medium-term plan entailed some fiscal easing, which would necessitate a tighter monetary stance than had previously been projected. 

Tone similar to September 

The tone of the MPC’s end-September statement was somewhat sterner than many had expected after the relatively mild tenor of the August statement. Of five Committee members, only three were fully in support of the Governor’s proposal to keep the policy rate unchanged, although a fourth voted in favour of it despite preferring to raise rates by 0.25 percentage points. The fifth member voted against the proposal, however, and would have preferred a 0.25-point rate hike. Closer examination of the MPC’s decisions reveals that, since the current rate decision process was adopted, on eight occasions two members have either voted against the Governor’s proposal or supported it only half-heartedly. And in four of those eight instances, the outcome of the interest rate decision immediately following turned out in line with the views of this two-member minority. 

The arguments in favour of an unchanged policy rate in September were, among other things, that inflation had risen more slowly than forecast, there was the possibility that employers would respond to wage increases by streamlining to a greater degree than previously thought, the scope for wage rises could be greater than previously estimated because of productivity growth and improved terms of trade, and the global inflation outlook was uncertain. 

The grounds for a rate hike in September were, among other things, that it was appropriate to consider the inflation outlook more than observed inflation, services inflation was on the rise following the wage agreements early in the year, the domestic economy was quite strong, and the fiscal stance had eased. 

All of these arguments (on both sides) are still valid, as only a short time has passed since the last rate-setting meeting. As in September, we think the arguments in favour of an unchanged policy rate will carry the day on 4 November. 

The forward guidance paragraph in the MPC’s last statement began as follows:

“If 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. How much and how quickly will depend on future developments and on how the current uncertainty plays out. 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.” 

In our opinion, the ultimate impact of the generous wage settlements of the past few months has yet to come clearly to the fore. Although domestic inflation has risen in the recent term, the effects are as yet considerably weaker than the CBI appears to have expected in its August forecast. It appears, then, that the scope mentioned in the quoted passage above still exists. On the other hand, we think it likely that the monetary tightening tone there will be retained in the next statement and that the MPC will follow through on it later on. 

We expect a 1.5-point increase in the effective policy rate 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 0.75-point nominal 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, reducing the amount of liquidity in circulation. 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. We consider this change the equivalent of a 0.75-point rate increase, bringing next year’s rise in the effective policy rate to 1.5 percentage points. In terms of the spread between the Bank’s policy rate and inflation, the monetary stance will tighten somewhat in H1/2016 and then ease again with rising inflation as the year progresses. 

If the capital account liberalisation strategy is implemented successfully in the coming term, it will be accompanied by increased uncertainty about the ISK exchange rate, which the CBI has managed effectively in the recent past. 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 without 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. 

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