Our forecast: unchanged policy rate on 24 August

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 24 August, 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 updated forecast to be published concurrent with the MPC’s upcoming interest rate decision. 

We expect the Committee to mention in its next statement that the monetary stance has tightened more than was expected in tandem with the current disinflation episode. Inflation expectations have eased downwards towards the target, and the near-term inflation outlook has improved in line with the recent ISK appreciation. As before, however, strong near-term growth in domestic demand and growing tension in the labour market could generate increased inflationary pressures and necessitate an increase in nominal interest rates. 

Inflation has tapered off, inflation expectations have fallen, and the monetary stance has tightened

Two CPI measurements have been published since the last policy rate decision. The index rose by 0.18% in June and fell by 0.32% in July. Headline inflation has fallen from 1.7% to 1.1% since the last interest rate decision date. Underlying inflation in terms of core index 3 has fallen from 2.2% to 1.4% since the MPC’s June meeting. Because of reduced inflation, the monetary stance has tightened in terms of the spread between past inflation and the CBI’s effective policy rate. The effective real policy rate is now 4.65% by this measure, up from 4.05 at the beginning of June.

Inflation expectations as expressed in terms of the spread between indexed and non-indexed bond market rates have subsided since the last interest rate decision. The five- and ten-year breakeven inflation rate in the bond market has fallen by 0.2 percentage points since the beginning of June, from 3.0% to 2.8%. The CBI’s real policy rate has therefore risen even in terms of the difference between the effective policy rate and the breakeven inflation rate in the bond market. It can be argued that the risk-adjusted breakeven inflation rate is now at or below the inflation target.

When the MPC meets this month, it will have in hand the results of the most recent survey of market participants’ inflation expectations. The last such survey was carried out in early May, in connection with that month’s interest rate decision and the publication of Monetary Bulletin 2016/2. According to the May survey, market participants expect inflation to measure 3.2% in one year and 3.4% in two years. We expect the new survey to show changes in these expectations in response to improvements in the near-term inflation outlook, at least. It is therefore likely that the monetary stance will also be tighter by that measure than it was in the spring. 

Vastly improved inflation outlook concurrent with ISK appreciation

The ISK exchange rate has risen by 5.3% since the last policy rate decision, even though the CBI has bought a substantial amount of currency in the interim. This has strongly affected both inflation and our own inflation expectations. According to our most recent inflation forecast, published on 12 August, inflation will remain very moderate in coming months and will be below the CBI’s target until year-end 2017. We expect it to average 1.6% in 2017 and to measure 2.2% by the end of that year; however, we project that it will pick up rapidly in 2018, bypassing the target early in the year and overtaking the 4.0% upper deviation limit in the third quarter.

In our opinion, the inflation outlook is much more favourable than that described in the CBI’s last inflation forecast, published concurrent with the 11 May policy rate decision. We consider that forecast too pessimistic about the impact of wage agreements on near-term inflation; furthermore, developments in the ISK exchange rate have diverged greatly from the CBI forecast. That forecast is based on the assumption that the trade-weighted exchange rate index (TWI) will hold unchanged at about 188.8 points throughout the forecast horizon. Now, however, the TWI sits at 178.7 and the ISK is about 5.6% stronger than the CBI specified in its forecast. This has considerable impact on inflation because of the large proportion of directly or indirectly imported goods in the consumer basket.

When it meets this month, the MPC will have in hand the CBI’s updated macroeconomic and inflation forecast, which will be published concurrent with the upcoming interest rate decision. We anticipate that the new inflation forecast will reflect the improved short-term inflation outlook. On the other hand, the bank’s forecast will be based on the assumption that the exchange rate will hold steady throughout the forecast horizon, which will translate to a near-term outlook more pessimistic than our own, as we expect the ISK to appreciate until mid-2017. Experience tells us that the CBI will probably hold fast to the view that the long-term inflation outlook is broadly unchanged and that inflation will rise markedly as 2017 progresses. We do not expect the revision of the GDP growth outlook to change this to any significant degree. However, we do think it possible that the bank will raise its 2016 GDP growth forecast of 4.5% somewhat and perhaps lower the forecasts for 2017 and 2018 (currently 4.0% and 3.0%, respectively), owing to weaker output growth among key trading partner countries and greater uncertainty about industrial development at home than was previously assumed. 

Policy rate unchanged in June, in line with forecasts

The MPC decided to keep the CBI’s policy rate unchanged at its last rate-setting meeting, held on 1 June. 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. The Committee mentioned that “[g]lobal price developments and a stronger króna have provided the scope to raise interest rates more slowly than was previously considered necessary. By the same token, there are signs that monetary policy has anchored inflation expectations more securely than before and contributed to a more moderate rise in inflation than could have been expected in the wake of large pay increases.” It goes on to say that “according to the Bank’s forecast from early May, 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, and all members voted in favour of the Governor’s proposal to keep rates unchanged. 

We forecast an unchanged policy rate throughout the forecast horizon 

The MPC raised the policy rate three times in 2015 – in June, August, and November – by a total of 1.25%, in response to the prospect of rising inflation, large domestic pay increases, and a widening output gap. Alongside these increases, the MPC issued clear forward guidance indicating the need for monetary tightening in the coming term, in view of growing domestic inflationary pressures. The MPC stressed that much and how quickly the monetary stance must be tightened would depend on future developments.

At its last five meetings, the MPC has decided to keep the policy rate unchanged, as inflation has developed much more favourably than the CBI had forecast. The real policy rate has been rising and is now rather high. The monetary stance therefore been quite tight and has been tightening further in response to reduced inflation and inflation expectations, among other factors. Despite deciding to keep nominal interest rates unchanged, the MPC has made no change to its forward guidance, stating that based on the CBI’s forecast, a tighter monetary stance will probably be needed in the coming term because of growing domestic inflationary pressures.

Because our forecast assumes low inflation, the real policy rate will remain high, and the monetary stance will be relatively tight over the majority of the forecast horizon, even without further nominal policy rate increases. In view of this, we expect the effective policy rate to remain unchanged in 2016 and 2017. 

Exchange rate developments highly uncertain 

If the capital account liberalisation strategy is implemented successfully, it will be accompanied by increased uncertainty about the ISK exchange rate, which the CBI has managed effectively in the recent past. It is likely that steps towards liberalisation will be taken before the planned Parliamentary elections on 29 October. 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 Iceland’s international investment position, we think it likely that the real exchange rate will continue to rise well into next year. In our opinion, this will happen partly in response to further nominal ISK appreciation, as we assume in our forecast.