Our forecast: unchanged policy rate on 16 March

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 16 March, its next decision date. The rationale for holding interest rates unchanged will probably be that inflation is below the CBI’s inflation target and looks set to remain low in the near future, according to the forecast published concurrent with the MPC’s February interest rate decision. 

We expect the MPC to say, as it did in February, that according to the Bank’s forecast, a tighter monetary stance will probably be needed in the coming term, in view of growing domestic inflationary pressures, and that how much and how quickly the monetary stance must be tightened will depend on future developments. Although the near-term inflation outlook has improved, inflation is likely to rise rather swiftly as the second half of the year progresses, overshooting the inflation target. 

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 the effective policy rate from the floor of the interest rate corridor to the centre, in response to reduced financial system liquidity. 

Our inflation forecast similar to the CBI’s

The consumer price index (CPI) rose by 0.68% in February, outpacing official forecasts, which lay in the range of 0.3-0.6%. Headline inflation now measures 2.2%, as opposed to 2.1% in January and at the time of the MPC’s last interest rate decision. Inflation has therefore risen marginally since the MPC’s February meeting. Inflation in terms of the CPI excluding housing is now 0.7%, up from 0.6% at the time of the last policy rate decision.

We expect inflation to taper off in March, to 1.7%, remain below target until the end of Q3, and then rise to 3.2% by the end of the year.

Our inflation forecast is broadly similar to the CBI’s for the remainder of this year. The CBI projects that inflation will overtake the 2.5% inflation target in Q4 but remain around 2% until then. Our 2017 forecast diverges from the CBI’s, however, in that ours is lower, although we both assume that inflation will be somewhat above target during the year.

When the MPC makes its next decision, it will have in hand the results of the most recent corporate inflation expectations survey, carried out among executives from Iceland’s 400 largest firms between 10 February and 2 March. According to the median response, survey participants expect inflation to measure 3.0% over the next twelve months, a reduction of 0.6 percentage points since the last survey, conducted in December. This is slightly below our forecast, but it could be due in part to survey respondents’ expectation that the króna will appreciate over the next twelve months. Respondents also expect the CBI’s collateralised lending rate to be 7.7% in twelve months’ time, whereas it was 6.5% at the time the survey was taken. 

2015 GDP growth close to forecasts 

GDP growth measured 4.0% in 2015, according to preliminary figures published by Statistics Iceland (SI) on 10 March. This is close to forecasts, as we had projected 4.3%, the CBI 4.1% ,and SI 4.2%.

The drivers of GDP growth were as forecasted: private consumption, investment, and exports. Because of rapid growth in imports, which in turn is connected to swift growth in domestic demand and exports, the contribution of net trade to GDP growth was negative. Nevertheless, there was a sizeable external trade surplus during the year, which is unusual in historical context, as GDP growth has been positive in Iceland since 2011.


GDP growth figures for 2013 and 2014 have been revised upwards, primarily due to an upward revision of business investment. GDP growth is now estimated at 2.0% in 2014 instead of the previously projected 1.8%, and GDP growth for 2013 has been revised upwards from 3.9% to 4.4%. This gives occasion to assume that productivity growth may have been stronger than previously thought during this period.

Because the above-mentioned SI figures are in line with the CBI forecast published at the time of the MPC’s February interest rate decision, they do not affect our expectations concerning the upcoming decision.

We expect GDP growth to be robust this year as well, as other forecasters do. We project 4.4% GDP growth driven by the same factors as in 2015: private consumption, investment, and growth in services exports. Indicators such as card turnover suggest robust private consumption growth so far this year. Our forecast for 2016 closely resembles the CBI’s newly published forecast, which provides for 4.2% GDP growth during the year. 

MPC unanimous in favour of unchanged interest rates at last meeting

According to the minutes of the MPC’s last meeting, no Committee members saw any clear reason to change the policy rate at that time. In members’ view, domestic inflationary pressures had increased somewhat since the last meeting. The deflationary effects of developments in global energy and commodity prices and the exchange rate of the króna were stronger than previously thought, however, and appeared likely to persist longer. Inflation was still below target, and opposing forces would continue to affect it. MPC members were of the view that uncertainty about the interaction between these factors had grown. They agreed that the overall picture had not changed much since the previous meeting. They had differing opinions about the weight of the factors that could affect inflation in the coming term, however. While some placed more emphasis on the global economy and considered it likely that global deflation could prove more pronounced and more protracted than previously thought, others were more concerned about the widening positive output gap and increased domestic inflationary pressures. In view of the discussion, the Governor proposed that the Bank’s interest rates be held unchanged, and the proposal was approved unanimously.

According to the minutes, members also agreed that no further changes should be made to reserve requirements at that time. There was continuing discussion of additional policy instruments other than interest rates that could be used to restrict capital inflows related to carry trade, and of the work being done towards developing such instruments. MPC members agreed on the importance of concluding this work as soon as possible. 

We expect a 1.25-point increase in the effective policy rate this year 

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 this summer. 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 in 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.

In view of the business cycle position, the sizeable surplus on external trade, and the good international investment position, we think it likely that the real exchange rate will continue to rise in the coming term. To a large extent, it will stem from larger cost price increases in Iceland than in trading partner countries. On the other hand, it is relatively likely that the nominal exchange rate will rise as well, although this is not what we have assumed in our forecast. If this does happen, inflation will probably turn out lower in the near future, and the MPC will be less likely to raise the policy rate this year.