We forecast an unchanged policy rate on 9 December

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 9 December, its next decision date. We expect the Committee to base its decision on both the current situation, with inflation still below the CBI’s inflation target – particularly in terms of the CPI excluding housing – and the outlook for a slower rise in inflation than was assumed in the bank’s most recent forecast. A stronger króna and global price developments have provided the scope to raise interest rates a bit more slowly than was previously considered necessary. 

We expect that, as in the statement accompanying the MPC’s last interest rate decision, the Committee will emphasise the need for a tighter monetary stance in the coming term. The main grounds, however, will be that although the near-term inflation outlook has improved, inflation is likely to rise rather swiftly in the second half of 2016 and overtake the target. Therefore, a stronger króna and global economic developments have not affected the need for a tighter stance further ahead. We expect a 1.25-point increase in the effective policy rate in 2016. Of that amount, we expect 0.5 percentage points to take the form of nominal rate hikes and the other 0.75 points 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. 

Inflation below the CBI forecast 

The CPI fell 0.35% in November, undershooting official forecasts, and headline inflation therefore rose less than generally expected. It now measures 2.0%, up from 1.8% in October. It has therefore risen since the last MPC meeting, mainly due to base effects; i.e., a 0.5% decline in the CPI in November 2014. Underlying inflation in terms of core index 3 excluding tax effects has also risen over the same period, from 2.1% to 2.3%. The CPI excluding housing declined by 0.6% between months, leaving inflation measured by this criterion unchanged at 0.3%.

In our opinion, the CBI was once again too pessimistic about inflation in its November forecast, in spite of having revised its August forecast sharply downwards. The CBI forecasts inflation at 2.3% in Q4/2015, 2.7% in Q1/2016, and 3.0% in Q2/2016. We project it to measure 1.9% in each of these quarters and expect it to remain below the 2.5% inflation target through the middle of next year, whereas the CBI’s November forecast indicated that it would overtake the target before the year-end and remain above it until at least end-2018. Our forecast and the CBI’s are more closely aligned further out the forecast horizon, although ours is lower for the entire period (through 2017).

The MPC will not have a new CBI inflation forecast in hand when it meets in December; however, it will probably agree with us in considering the CBI’s November inflation forecast overly pessimistic, at least for the short term, and take that into account when making its policy rate decision. 

Treasury bond yields down since November interest rate decision

Nominal Treasury bond yields have risen by 0.4-0.6 percentage points since the MPC’s interest rate decision in early November. The increase comes on the heels of a decline of 0.3-0.6 percentage points between the end-September and early November meetings. The increase in indexed Treasury bond yields since the last meeting is about 0.4 percentage points, following a 0.2- to 0.4-point decline between the September and November meetings. 

The MPC interpreted the decline prior to the November meeting as a sign that the monetary policy transmission mechanism had weakened because the higher policy rate had not resulted in higher rates at the longer end of the yield curve. Presumably, the rise since the MPC’s last meeting has put those concerns to rest, at least temporarily, and reduced the need to heave up the long end of the yield curve with high short-term rates. On the other hand, the MPC is devising ways to narrow the effective interest rate spread vis-à-vis foreign investors by imposing some sort of controls on capital inflows. 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. 

Effective policy rate to rise with the winding-up of the old banks 

According to the minutes of the last MPC meeting, the Committee discussed developments in liquidity in connection with capital account liberalisation. Members thought it likely that the liquidity position could change, which could affect the need for further changes in the interest rate. This is the first explicit statement that the CBI’s interest rate policy will be determined in part by changes in liquidity in connection with the winding-up of the old banks and the upcoming foreign currency auction, which will presumably reduce effective liquidity considerably and function as the equivalent of a rise in the effective policy rate. Most likely, the MPC will want to see these effects before assessing the need for further monetary tightening in the form of nominal rate hikes, and the effects will hardly be in evidence before the end of Q1/2016. 

GDP growth projected to have been strong in Q3 

Key economic variables indicate robust activity in the domestic economy at present. This will doubtless show in the GDP figures published by Statistics Iceland (SI) on 8 December, the day before the MPC’s interest rate announcement. The GDP data released next week will extend through Q3/2015 and will include a revision of H1/2015 figures. We expect the numbers to show significant growth in both domestic demand and services exports, in line with the CBI forecast and our own. Our GDP growth forecast for 2015 and the CBI’s are quite similar; we project growth for the year at 4.3%, and the CBI forecasts it at 4.6%. 

We expect forward guidance indicating further policy rate hikes

According to the minutes from the last MPC meeting, there was no discussion of a rate hike in excess of 0.25 percentage points. The possibility of keeping rates unchanged was discussed, however. When the interest rate decision was put to a vote, all members voted in favour of the Governor’s proposal to raise the policy rate by 0.25 points. Some members supported the rate hike as much because they considered it necessary to stand by the Committee’s previous message as because of a need for a tighter stance at that time. 

The tone in the MPC’s last statement signalled further rate hikes ahead, in view of growing domestic inflationary pressures. We expect no change in this message in next week’s statement. 

We expect a 1.25-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 0.5-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 1.25 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.