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Policy rate cut in defiance of forecasts

The Central Bank of Iceland’s (CBI) Monetary Policy Committee (MPC) decided today to lower the policy rate by 0.5 percentage points, surprising us and other forecasters who had expected an unchanged CBI interest rate. According to this morning’s MPC statement, “[i]n spite of large pay increases and a wider positive output gap, inflation has remained below target for two-and-a-half years.” Furthermore, the MPC noted that the inflation outlook has improved since the CBI’s last forecast, and if the exchange rate remains unchanged, the outlook is for inflation to remain below target until early 2017. 

Forward guidance shifts into neutral

The forward guidance provided by the MPC has been toned down substantially since the last interest rate decision, as we had forecast. The Committee now takes a neutral tone as regards the steps to come and, at the end of this morning’s statement, says that “[w]hether interest rates will be lowered further or need to be raised again will depend on economic developments and on the success of the capital account liberalisation process”. It is somewhat surprising that there is no mention of the need for a wide interest rate spread during liberalisation, now that the time has finally come. But the interest rate spread will remain wide in the near future. 

 

Monetary policy has delivered lower inflation 

In this morning’s statement, the MPC says that tight monetary policy has contained demand for credit, increased saving, and supported a larger current account surplus and a stronger króna. In this way, according to the Committee, tight monetary policy has led to lower inflation; furthermore, inflation expectations have fallen in the recent term and have aligned more closely with the inflation target. For the same reasons, real interest rates have fallen somewhat in the recent past. The MPC has expressed doubts recently about how well the breakeven inflation rate reflects inflation expectations, but these doubts are not in evidence now. The ten-year breakeven inflation rate is 2.5% following today’s interest rate decision, which indicates that inflation expectations are, if anything, below target.  

CBI much more upbeat about the inflation outlook

At first perusal, the CBI’s new inflation forecast appears considerably more optimistic than the May forecast. To be sure, the bank has significantly lowered its forecast of developments in the CPI between Q2 and Q3 of this year, owing mainly to the past few months’ appreciation of the ISK. In addition, productivity growth is stronger than previously expected and the rise in unit labour costs accordingly smaller, which results in weaker domestic cost pressures. As before, the forecast of developments in the CPI in coming quarters is virtually unchanged from the CBI’s last forecast, as the bank still expects inflation to pick up strongly in the near future. If the ISK appreciates further, it is highly likely that inflation will remain lower in the near term than the CBI forecasts today, and this could affect upcoming interest rate decisions. It is worth noting that the CBI’s inflation forecast is considerably more pessimistic than our own. The confidence bands of the forecast are more symmetric than before, however, reflecting the MPC’s more neutral stance on future developments in the policy rate. 

Increased credibility provides greater flexibility

At this morning’s press conference, the Governor stated that recent inflation developments, the appreciation of the ISK, and the reduction in inflation expectations had made it possible to keep inflation at target with a lower interest rate than was previously considered necessary. He noted that this was a welcome development and a sign that monetary policy had gained increased credibility, which in turn provided for increased flexibility. In response to the question of whether monetary policy had been too tight in the recent past, he said, among other things, that credibility had been lacking and a tighter monetary stance had been needed as a result. 

Possible change in exchange rate assumptions in CBI inflation forecasts

The Governor noted in particular that the constant exchange rate provided for in the CBI’s inflation forecasts was a technical assumption rather than a forecast. He said that this should be borne in mind in any scrutiny of recent CBI inflation forecasts and the accuracy of those forecasts. He also said that, in the wake of changes in the CBI’s foreign exchange market intervention policy and following the upcoming steps towards capital account liberalisation, the bank would assess the pros and cons of assuming a variable exchange rate in its forecasts. In our opinion, this would be a positive step, particularly in view of the importance of the exchange rate in inflation developments. 

GDP growth outlook broadly unchanged

The updated GDP growth forecast published concurrent with today’s interest rate decision provides for slightly stronger growth in 2016 and 2017. The CBI projects GDP growth at 4.9% this year and 4.1% next year, up from 4.5% and 4.0%, respectively, in its last forecast. With this, the CBI is moving closer to our own GDP growth forecast of 5.4% for 2016 and 4.0% in 2017. On the other hand, the bank lowered its forecast for 2018 from 3.0% to 2.6%; therefore, it considers the GDP growth outlook for the forecast horizon as a whole to be broadly unchanged. 

Strong impact on the domestic financial market

Domestic markets have responded strongly to this morning’s decision. Yields on indexed and nominal bonds have fallen markedly, and share prices have risen. This response indicates w how unexpected the MPC’s decision was, and that the Icelandic market now expects somewhat lower interest rates in the coming term than it did previously. 

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