Our forecast: unchanged policy rate on 10 February

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 10 February, its next decision date. Presumably, the Committee’s rationale for an unchanged policy rate will be that inflation is below the CBI’s inflation target and that, according to the bank’s new forecast, to be published concurrent with the interest rate decision, the outlook is for inflation to rise somewhat more slowly than was assumed in the previous CBI forecast, issued last November. 

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, somewhat exceeding the target, over the course of H2/2016. We assume that the MPC will say that a stronger króna and international developments have not affected the need for a tighter monetary stance over the medium term, even though they have provided the scope to raise interest rates more slowly than was previously thought necessary. We expect the effective policy rate to rise by a total of 1.25 points 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 consumer price index (CPI) fell 0.6% in January, a modest decline in comparison with published forecasts, which lay in the 0.6-0.8% range. Headline inflation now measures 2.1%, as opposed to 2.0% in December, when the MPC announced its last interest rate decision. Inflation has therefore risen marginally since the last MPC meeting. The CPI excluding housing now measures 0.6%, up from 0.3% at the time of the last policy rate decision.

In our opinion, the CBI was too pessimistic about inflation in its November forecast, in spite of having revised its August forecast sharply downwards. The bank forecasts that inflation will overtake the 2.5% inflation target in Q1/2016, whereas we expect it to remain below target through mid-year. 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 have the CBI’s new inflation forecast in hand when it meets to set the interest rate. For the short term, the new forecast will doubtless be lower than the November forecast. The main difference will be in base effects – i.e., inflation has been below CBI forecasts since November. On the other hand, the forecast will reflect the tug-of-war between lower petrol prices and stronger domestic cost pressures from larger contractual wage increases during the forecast horizon. We expect the more rapid pay increases provided for in the new wage agreements between the Confederation of Icelandic Employers (SA) and the Icelandic Federation of Labour (ASÍ) to raise the wage index by an additional 0.3% this year, 0.6% in 2017, and 0.4% in 2018, over and above the previous contracts. This will exacerbate domestic inflationary pressures, although the CBI did anticipate this to a degree in its November forecast. Offsetting this, oil prices have developed much more favourably than the CBI assumed in November. 

GDP growth outlook broadly unchanged; radical changes in oil prices 

The CBI will publish its new macroeconomic forecast concurrent with the next interest rate decision. We expect it to be quite similar to the November forecast. Recent economic indicators, including those from the labour market, suggest that 2015 GDP growth was close to the CBI forecast of 4.6%. The CBI projects GDP growth at 3.2% this year and 2.9% in 2017.

The global GDP growth outlook for 2016 and 2017 has deteriorated somewhat since the CBI published its last forecast. For example, the International Monetary Fund’s (IMF) projects in its January forecasts that GDP growth in the US will be 0.2 percentage points lower this year and next year than in its October forecast. On the other hand, the Fund expects 0.1 percentage point stronger growth in the eurozone than in its previous forecast. In addition, the IMF expects GDP growth to be stronger in 2016 than in 2015 in both the US and the eurozone, while it projects broadly flat year-on-year growth in the UK. The Fund also expects growth to remain more or less flat between 2016 and 2017.

One of the biggest changes in Iceland’s external conditions since the last CBI forecast is the price of oil, which has fallen markedly in the recent term. This development has boosted terms of trade, widened the trade surplus, enhanced GDP, and lowered inflation. However, the ultimate impact will be determined by the duration of the price reduction, as near-term developments in oil prices are highly uncertain at present. 

We expect forward guidance indicating further policy rate hikes

According to the minutes of the last MPC meeting, raising the policy rate was not discussed at that time. The Governor proposed that the Bank’s interest rates be held unchanged, and the proposal was approved unanimously. The forward guidance provided by the Committee at the time of the last interest rate decision was that, “according to the Bank’s November forecast, a tighter monetary stance will probably be needed in the coming term, in view of growing domestic inflationary pressures.” The Committee agreed that a stronger króna and more favourable global price developments had provided the scope to raise interest rates more slowly than was previously considered necessary. We expect the MPC to maintain this tone now, even though inflation has developed much more favourably than the CBI projected in November and the short-term inflation outlook has improved. The risk of domestic inflationary pressures still exists, and the likelihood is that inflation will rise rapidly as the second half of the year progresse. The MPC will fine-tune its forward guidance to take account of this. 

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 this year. We project a 0.5-point policy rate hike in the fourth quarter. 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, which we expect to happen in March-April. 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 this 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 advances.

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.