Policy rate unchanged – in line with forecasts

The Central Bank (CBI) Monetary Policy Committee’s (MPC) decision to keep the policy rate unchanged, announced today, was in line with our projections and those of most other official policy rate forecasters. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5.25%. 

The MPC’s arguments in favour of an unchanged policy rate were as we expected: inflation has risen markedly since the last interest rate decision, and GDP growth is strong and the GDP growth outlook improving. In the Committee’s opinion, these factors, together with the impact of Statistics Iceland’s (SI) correction, offset the recent appreciation of the ISK and the fact that inflation expectations are still close to target. 

Neutral forward guidance again

Some of today’s MPC statement is copied verbatim from the last statement, as regards signals of upcoming monetary policy decisions. Nonetheless, the forward guidance is neutral, as before, and the Committee stresses the current need for caution in setting interest rates. The monetary stance in the coming term will depend on economic developments and the success of the capital account liberalisation process. 

MPC focused on upcoming capital account liberalisation

In this, the MPC appears to have the ISK in its crosshairs, as upcoming steps towards liberalisation of the capital controls will usher in greater uncertainty about exchange rate developments. To an increased extent, the greater freedom of capital movement will release the exchange rate from the CBI’s control, and the exchange rate could become more volatile as a result. The MPC appears to prefer to exercise caution as regards further changes in the policy rate until this step has been taken. 

Next interest rate decision 16 November 

At this morning’s press conference and presentation of the interest rate decision, the Governor mentioned that by the time the MPC convened for its next decision, scheduled for 16 November, it would have the CBI’s new macroeconomic and inflation forecast in hand and the first steps towards liberalisation would probably have been taken. It is clear that the Committee will have extremely important information at its disposal concerning its policy rate decision and the upcoming steps in monetary policy. The Governor said that, in view of the expected moves towards liberalisation, the Bank might decide to include the exchange rate as a forecast variable in its November forecast, whereas in recent years it has based its projections on the technical assumption that the exchange rate would remain unchanged. 

Unconcerned about the cost of maintaining large FX reserves

As regards the cost of the CBI’s foreign exchange reserves, which are quite large at present, the Governor noted that everyone had large reserves at this juncture and that it was expensive because reserve currencies are low-yielding. He went on to say that it was unnecessary to overemphasise this expense, as it was not a problem even though the reserves were somewhat above the minimum recommended size. He stressed that it was well to bear in mind that the capital controls had not yet been lifted and that the CBI needed to be prepared to withstand the outflows that could occur in the worst-case scenario. Furthermore, there would be many opportunities to unwind the reserves in the future, and hopefully conditions conducive to narrowing the spread between domestic and foreign interest rates would develop as well. 

Previous interest rate decision based on incorrect assumptions 

The Deputy Governor said at the press conference that the previous policy rate cut had been based in part on incorrect assumptions, caused by the error in SI’s inflation measurements. The Governor added that the market had temporarily overreacted for to that decision.

So far this morning, yields on nominal bonds have risen in response to the policy rate decision, although market turnover has been modest as yet.