0.25% interest rate cut expected on 16 November
We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to lower the bank’s policy rate by 0.25 percentage points on 16 November, its next decision date. The rationale for the rate cut 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. Owing to a marked appreciation of the ISK since the MPC’s last meeting and the CBI’s last inflation forecast, the inflation outlook has improved substantially.
We expect the MPC to specify in its statement that inflation expectations are close to target and have fallen in tandem with the appreciation of the ISK. When it meets next week, the Committee will have in hand the results of the most recent survey of financial market agents’ inflation expectations. On the other hand, the MPC will also have the CBI’s newest GDP growth forecast, which will probably provide for stronger GDP growth and more demand pressures in the economy than the bank has forecast previously. Furthermore, there is considerable uncertainty about the status of wage settlements in coming months and about the formulation of a new Cabinet in the wake of the recent Parliamentary elections.
Vastly improved short-term inflation outlook concurrent with ISK appreciation
The ISK exchange rate has risen by over 4% in trade-weighted terms since the last policy rate decision in early October, even though the CBI has bought a substantial amount of currency in the interim. Also in terms of the trade-weighted index, the ISK has appreciated by more than 9% since the CBI issued its last inflation forecast in August.
This has strongly affected both inflation and inflation expectations. According to our most recent inflation forecast, published in October, inflation will remain very moderate in coming months and will be below the CBI’s target until well into 2018. This forecast is based in part on our assumption that the ISK will appreciate in the near future. However, the ISK has appreciated much more rapidly than we had anticipated, and the near-term inflation outlook has improved even more we projected in our October forecast. We expect inflation to rise quickly until 2018 and overtake the inflation target at the beginning of that year because of a depreciation of the ISK. We also forecast that GDP growth will ease in 2018.
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 is much more favourable than that described in the CBI’s last inflation forecast, published concurrent with the August policy rate decision. The CBI’s last forecast was based on the technical assumption that the trade-weighted exchange rate index would remain unchanged throughout the forecast horizon, whereas the reality has been anything but: the ISK has appreciated by over 9% from the value underlying that forecast. Clearly, then, the new forecast will be based on a much stronger ISK than the last one. This alone has considerable impact on near-term inflation because of the large proportion of directly or indirectly imported goods in the consumer basket.
We think it likely that the CBI will make a fundamental change in the new inflation forecast by abandoning the assumption of an unchanged exchange rate in favour of an exchange rate path entailing near-term ISK appreciation followed by depreciation further along in the forecast horizon. This will further improve the inflation outlook in the short run and weaken it towards the end of the forecast period.
Factors offsetting the ISK appreciation
Many factors could offset the effects of the ISK appreciation on inflation developments in the coming term. First of all, there is growing unrest in the labour market, and it is less certain that the current wage agreements will hold than it was when the CBI issued its last Monetary Bulletin. Second, the CBI’s upcoming GDP growth forecast will probably assume stronger growth and a larger output gap during the forecast horizon than the August forecast did. According to the minutes from the last MPC meeting, the Committee was of the view that the most recent indicators suggested that GDP growth could turn out stronger than it had previously expected. In this context, we would like to point out that the year-2017 output growth forecast published by the CBI in August is somewhat below our own, at 4.1%, as opposed to our projection of 5.1%. Third, efforts to form a new Government after last month’s Parliamentary elections have borne no fruit as yet, generating uncertainty on that score.
And finally, even if the CBI’s new inflation forecast reflects an improved near-term outlook due to the appreciation of the ISK, we expect the bank to stick to its opinion that inflation will rise significantly as the forecast progresses. This is broadly in line with the path outlined in our own inflation forecast. In this context, it can be assumed that the exchange rate path underlying the CBI’s new forecast will entail a depreciation of the ISK in the latter half of the forecast horizon, which will ease the tension in the economy.
Unchanged policy rate in October and neutral forward guidance, in line with forecasts
On 5 October, the MPC’s last interest rate decision date, the Committee decided to keep the policy rate unchanged, in line with our projections and those of most other official policy rate forecasters. The MPC’s arguments in favour of an unchanged policy rate were as we expected: inflation had risen markedly since the last interest rate decision (partly because of Statistics Iceland’s correction of its measurement error), and GDP growth was strong and the GDP growth outlook was improving. This, in the Committee's opinion, offset the impact of the recent ISK appreciation and the fact that inflation expectations remained at target.
The forward guidance in the MPC’s October statement was neutral, as before. The Committee noted the need for caution in interest rate setting and stated that the monetary stance in the coming term would depend on economic developments and the success of the capital account liberalisation process. In this, the MPC appeared to have the ISK in mind, as upcoming steps towards liberalisation of the capital controls would usher in greater uncertainty about exchange rate developments. The MPC therefore appeared to prefer to exercise caution as regards further changes in the policy rate until this step had been taken. Now that the first step in the process has been taken, uncertainty seems to have diminished, as this initial liberalisation has not yet generated downward pressure on the exchange rate. Furthermore, the foreign exchange reserves have grown significantly since the last interest rate decision and the CBI is therefore in an even better position vis-à-vis upcoming steps in the liberalisation process.
We expect another rate cut of 0.25 percentage points in Q1/2017
The monetary stance is quite tight at present in terms of the spread between the policy rate and either current inflation or inflation expectations. Because of modest near-term inflation in our forecast – and presumably, in the CBI’s upcoming forecast – the real policy rate will remain high if the nominal policy rate is unchanged. In essence, then, the monetary stance will continue to be tight in the near future. If inflation develops in line with these forecasts, we think it likely that the MPC will lower the policy rate further in early 2017, perhaps concurrent with the publication of its next macroeconomic and inflation forecast next February.
Thereafter, we expect the MPC to keep the policy rate unchanged for the remainder of the forecast horizon. The real policy rate will begin to taper off, however, as 2018 progresses and inflation starts to pick up.
Future developments in the policy rate will depend in part between the interaction between fiscal and monetary policies, and the formation of the next Cabinet could affect the policy mix during the horizon of our forecast. This aspect of the forecast is highly uncertain. That said, we expect the Government to support monetary policy with a conservative stance during the current upswing. The central government’s financial position has already improved substantially, as can be seen, among other things, in the recent decision by Moody’s to upgrade the sovereign to A-level ratings. In view of the improved position and the consolidation in many areas of public sector finance in recent years, there are vociferous demands for increased spending by both central and local governments. We think it likely that this will cause a greater divergence between monetary and fiscal policies than would be desirable.
Exchange rate developments highly uncertain
The ISK exchange rate is a major factor in the policy rate path presented in this forecast. We assume that the ISK will continue to strengthen until H2/2017, by roughly 5% from the current level. We then expect it to weaken again, as the real exchange rate will be quite high, GDP growth and demand pressures will start to ease, and trade-related foreign currency inflows will begin to abate, cutting into the current account surplus. A weaker currency will bring higher inflation, although the outlook for more moderate rises in wage costs and house prices in the latter half of the forecast horizon will cushion the impact. As inflation rises, inflation expectations can be expected to rise also. We expect this to cause the real policy rate to decline, thereby easing the monetary stance over the course of 2018. It should be noted, though, that this exchange rate forecast is highly uncertain, which creates corresponding uncertainty about the above-described inflation and policy rate forecast.