Our forecast: unchanged policy rate on 11 May

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 11 May, 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 modest in the near future, according to the forecast to be published concurrent with the MPC’s upcoming interest rate decision. 

We expect the MPC to say, as it did last time, that according to the CBI 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 marginally, inflation is likely to rise rather swiftly towards the end of the year and over the course of 2017, overshooting the inflation target. 

Inflation has been below the CBI forecast 

The consumer price index (CPI) rose by 0.21% in April, below official forecasts, which lay in the range of 0.3-0.4%. Headline inflation now measures 1.6%, as opposed to 2.3% in March, when the MPC announced its last interest rate decision, has therefore subsided slightly since the last MPC meeting. Inflation in terms of the CPI excluding housing is now 0.2%, down from 0.7% at the time of the last policy rate decision. 

We expect inflation to be moderate in coming months and to remain below the CBI’s inflation target throughout this year. However, we project that it will rise above the target early in 2017 and remain above it for the rest of the year. If this forecast materialises, inflation will have been below target for three years by the time it overtakes it in 2017. 

The MPC will have the CBI’s new macroeconomic and inflation forecast at hand when it meets this month. In our opinion, the inflation outlook has improved somewhat since the CBI’s last inflation forecast, published in February. We project that Q2/2016 inflation will be well below the February forecast, measuring about 1.5%, as opposed to the CBI’s forecast of 1.9%. According to our own forecast, it will remain below the CBI’s February forecast until the second half of 2018. 

 When the MPC meets this month, it will have the results of the most recent survey of market participants’ inflation expectations. The last such survey was carried out in early February, in connection with the interest rate decision and the publication of Monetary Bulletin 2016/1. According to that survey, market participants expect inflation to measure 3% in one year and 3.5% in two years. We assume that these changes in expectations reflect the above-described changes in the inflation outlook. 

GDP growth outlook still good 

The CBI will publish its new macroeconomic forecast concurrent with the next interest rate decision. The new forecast will be based, among other things, on year-2015 GDP figures, published after the last forecast. According to those figures, GDP growth measured 4.0% in 2015, close to the CBI’s forecast of 4.1%. 


It can be assumed that the CBI’s new forecast will provide for stronger GDP growth this year than in 2015. Payment card turnover and import figures suggest strong growth early this year in items related to private consumption and investment. Domestic demand therefore seems to be growing briskly at present. Services exports are growing rapidly as well, particularly to include tourism-generated foreign exchange revenues. The drivers of GDP growth look set to be broadly the same as in 2015: private consumption, business investment, and services exports. Because of the surge in imports, which in turn is connected to swift growth in domestic demand and exports, the contribution of net trade to GDP growth can be expected to be negative. In spite of this, there will be a significant external trade surplus this year, which is unusual in historical context, as Iceland’s GDP growth has been consistently positive since 2011. 

Effective policy rate still near the floor of the interest rate corridor 

Liquidity in circulation could decline concurrent with the settlement of the failed banks’ estates and the release of offshore ISK from the domestic economy. The MPC could decide to respond to this by either changing the interest rate corridor – i.e., narrowing it – or by lowering the entire set of interest rates. MPC members have stated that if and when this change takes place, it is not part of monetary policy, but if the Committee is disposed to tighten the monetary stance at the same time, it might take the opportunity to let the increase emerge in a tighter stance. Shifting the effective policy rate towards the centre of the interest rate corridor will mean smaller changes in the nominal policy rate than would otherwise have been necessary. 

The MPC closely monitors market interest rates and the banks’ liquidity in connection with this. If the liquidity position of at least some of the banks turns negative, then the CBI’s key rate will shift from its term deposit rate to its collateralised lending rate, which is now 0.75 percentage points above the deposit rate. If the banking system as a whole begins to take collateralised loans, the CBI’s effective policy rate will rise by this amount. If the MPC does not wish to raise the effective policy rate in this way, it could shift the entire interest rate corridor downwards by 75 basis points. If interbank rates begin to rise from the term deposit rate, it could be a sign that this is happening. There no indications of it at present, however. 

Policy rate unchanged in March, in line with forecasts

The MPC decided to keep the CBI’s policy rate unchanged at its last rate-setting meeting, held in March. This was in line with our forecast and others. The forward guidance in the MPC’s statement was also repeated verbatim from the previous statement. According to the statement, “[g]lobal price developments and a stronger króna have provided the scope to raise interest rates more slowly than had previously been considered necessary. However, this does not change the fact 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. How much and how quickly the monetary stance must be tightened will depend on future developments.”

According to the minutes from that meeting, no Committee members saw any clear reason to change the policy rate at that time. Committee members agreed that it was appropriate to pause and hold rates unchanged, as the Bank’s new forecast, including an assessment of the effects of recent developments on the medium-term inflation outlook, would be available at the time of the next meeting. In view of the discussion, the Governor proposed that the Bank’s interest rates be held unchanged, and all Committee members voted in favour of the proposal. 

We expect a 0.75-point increase in the effective policy rate in 2016 and 2017 combined 

We expect the MPC to respond to increased inflation, mounting tension in the economy, and a more accommodative monetary stance by raising the effective policy rate towards the end of this year. We project a 0.5-point increase in the effective policy rate in the fourth quarter, followed by another increase of 0.25 percentage points early in 2017. 

It is conceivable that this change will take place (either partly or entirely) when the effective policy rate moves closer to the centre of the interest rate corridor. The timing of this change – and whether it happens in the near future – is highly uncertain. In our estimation, it will have an impact equivalent to a 0.75-point increase in the effective policy rate. If it takes place at the same time that the MPC considers it convenient to raise the nominal policy rate, it will not constitute an actual policy rate increase. 

Exchange rate developments highly uncertain 

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 supports this assumption, 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 dramatic improvement in the international investment position, we think it likely that the real exchange rate will continue to rise in the coming term. To a large extent, the appreciation 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 it does happen, inflation will probably turn out lower in the near future, and the MPC will be less likely to raise the effective policy rate this year and next.