Policy rate unchanged, in line with forecasts

The Central Bank (CBI) Monetary Policy Committee (MPC) decided to keep the policy rate unchanged today, in line with our forecast and others. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5.75%. 

Forward guidance virtually unchanged

The forward guidance in the MPC’s statement is largely unchanged from the statement accompanying the last decision. According to today’s 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.”

However, in its rationale for unchanged interest rates, the MPC adds that there are now signs that “monetary policy has anchored inflation expectations more securely than before and contributed to smaller rises in inflation than could have been expected in the wake of large pay increases.” 

CBI still forecasts much higher inflation than we do

According to the new CBI forecast, inflation will be lower in 2016 than the bank projected in its last forecast, published in February. The new forecast indicates, however, that inflation will rise rapidly in the latter half of the year. As a result, the CBI projects that inflation will overtake the inflation target in the fourth quarter, just as it did in February. The CBI expects inflation to rise above the target sooner than we do. According to our forecast, it will not surpass the target until Q1/2017. The CBI’s forecast of average year-2017 inflation – 4.1% – is also much higher than our own forecast of 3.2%. 

GDP growth outlook has improved

The GDP growth outlook has improved slightly, according to the CBI’s new forecast. The CBI now projects 2016 GDP growth at 4.5% instead of the previous 4.1%. It also forecasts year-2017 GDP growth at 4.0%, as opposed to its previous projection of 3.4%. The difference lies mainly in more rapid private consumption growth in both years, as well as stronger investment growth in 2016 and a more favourable contribution from net trade in 2017. The CBI expects the output gap to be wider in the near future as a result, as the growth rate will exceed potential output, which the bank estimates at roughly 3% per year. 

Modest scope for nominal ISK appreciation 

According to the results of the CBI’s research, the equilibrium real exchange rate of the ISK has risen in the recent term. The main reason for this, in the bank’s estimation, is that the external balance of the economy has improved with the improvement in terms of trade and stronger exports, particularly in recent years, with the surge in services exports. The CBI’s findings indicate that the recent rise in the real exchange rate is attributable in large part to the adjustment of the real exchange rate to a higher equilibrium level and that it therefore reflects a normal adjustment of the economy to a higher expenditure level than in recent years.

At this morning’s press conference, where CBI officers explained the interest rate decision, the Governor indicated that there is some scope for a nominal appreciation of the ISK at present, although it is unclear how much. According to the Governor, the CBI is using that scope to accumulate foreign exchange reserves. The bank will continue to top up its tanks to the level it considers necessary to release offshore krónur and retain strong enough reserves to maintain credibility during the capital account liberalisation process. The Governor pointed out that the real exchange rate has exceeded its equilibrium level during upswings in the past but that this has partly been a reflection of economic policy. 

We expect an increase in the effective policy rate towards the end of 2016 

As before, we expect the MPC to respond to increased inflation, mounting tension in the economy, and a more accommodative monetary stance with further increases in the effective policy rate hikes this year and next. We expect a 0.75 percentage point increase in the effective policy rate over this period.