We forecast an unchanged policy rate on 14 December

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 14 December, its next decision date. The grounds for the decision will presumably be that even though inflation and inflation expectations are still at target, strong demand growth, uncertainty about fiscal policy further ahead, unrest in the labour market, and uncertainty about capital account liberalisation all call for an unchanged policy rate. The Committee will probably mention as well that even though inflation is below the CBI’s inflation target, it has risen since the MPC’s rate-setting meeting, in line with the bank’s forecast. Furthermore, the MPC will doubtless note that 2016 GDP growth looks set to exceed the bank’s forecast. 

In our opinion, the MPC is likely to continue with neutral forward guidance in next week’s statement and will probably repeat its November statement that “[t]he monetary stance in the coming term will depend on economic developments and actions taken in other policy spheres.” 

Inflation on the rise but appears likely to remain below target 

Inflation has risen since the CBI’s November interest rate announcement. It now measures 2.1%, up from 1.8% at the time of the last MPC meeting. The outlook is for Q4/2016 inflation to be in line with the bank’s forecast of 2.1%, up from 1.3% in Q3. Inflation is driven by steep domestic cost price increases and a widening output gap in the wake of hefty pay rises and accelerating housing inflation, on the one hand, and substantial appreciation of the ISK and low imported inflation, on the other.

The ISK has appreciated by about 2% in trade-weighted terms since mid-November, even though the CBI bought a substantial amount of foreign currency during the period – indeed, its FX purchases in November were three times larger than in November 2015. The ISK has strengthened by over 19% in trade-weighted terms since the beginning of the year. This has strongly affected inflation during the period and will continue to do so in the months to come.

The near-term exchange rate outlook has changed, in our opinion, and the ISK can now be expected to strengthen more than before. This is due in part to a more favourable current account balance than previously anticipated, a marked improvement in Iceland’s external position, and stronger-than-expected GDP growth. At the same time, the short-term outlook for wages and house prices has changed, and larger increases can be expected. Overall, the near-term outlook is for larger rises in domestic costs, which will tend to counterbalance the impact of the rising ISK on inflation.

According to our most recent inflation forecast, published together with this policy rate forecast, inflation will remain below the CBI’s target well into 2018. This is somewhat below the CBI’s own forecast. However, we expect inflation to rise somewhat in 2018, overtake the target around mid-year, and exceed the CBI’s forecast. 

Year-2016 GDP growth to top CBI forecast 

GDP growth measured a solid 6.2% in the first nine months of the year, the strongest growth rate yet measured in the current upswing, according to figures published by Statistics Iceland (SI) on 7 December. The nine-month growth rate is somewhat above the CBI’s forecast for the year as a whole, as the bank had projected growth at 5.0% in its mid-November forecast. The figures suggest that the output gap is widening somewhat more rapidly than the CBI assumed in that forecast.

Domestic demand is growing swiftly at present, with SI figures indicating a growth rate of 9.3% over the first nine months of the year. Both private consumption and investment are buoyant at the moment, albeit only marginally above the CBI’s forecast of 8.7%. This reflects the offsetting effects of stronger-than-expected investment growth and weaker-than-expected private consumption growth. The contribution of net trade to GDP growth appears set to be more favourable than was assumed in the CBI’s forecast, thanks to a booming tourism sector. 

Unchanged policy rate in November and neutral forward guidance

The MPC decided to keep the CBI’s policy rate unchanged on 16 November. According to the MPC statement published then, the outlook is for stronger GDP growth in 2016 and 2017 than the CBI had forecast in August, and “there are clearer signs that rapid demand growth is straining domestic resources.” On the other hand, the forecast published concurrent with that decision assumes much lower inflation than the CBI had projected in August, although “the change in the Bank’s inflation forecast does not provide as much scope for monetary policy response as might be expected, as the MPC had already incorporated a strong probability of further appreciation of the currency into its recent policy decisions.”

Two MPC members voted against the Governor’s proposal to keep the policy rate unchanged in November. Both of them wanted to lower it by 0.25 percentage points. The proposal was passed, however, with a vote of 3 against 2. According to the minutes from that meeting, the main grounds for a rate cut were that the monetary stance had tightened more than previously expected, owing to the appreciation of the ISK. The outlook was for the ISK to keep strengthening well into 2017. Such a tight stance was not entirely appropriate in view of developments in inflation, and therefore, it could be appropriate to ease the tightening caused by the currency appreciation. 

We expect rate cut of 0.5 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 both our forecast and the CBI’s, the real policy rate will remain high if the nominal policy rate is unchanged. It can therefore be assumed that the monetary stance will remain tight in the near future.

The CBI will publish its updated macroeconomic and inflation forecast in February 2017. The larger-than-forecast ISK appreciation will lower the bank’s near-term inflation forecast, as the currency is already nearly 3% stronger than the CBI has projected that it will be next year. We expect the ISK to be an average of 8% stronger in 2017 than the bank assumed in its November forecast. Offsetting the impact of a stronger currency on inflation and the inflation outlook will be the expected effect of a larger output gap. We expect that in Q1 – most likely in February – the MPC will respond to the improved inflation outlook with a rate cut of 0.25 percentage points.

We expect another 0.25-point rate cut in Q2, as the CBI will publish a new inflation and GDP growth forecast in May. Thereafter, we expect the MPC to hold the policy rate unchanged for the remainder of the forecast horizon, which extends through end-2018. The monetary stance will ease in 2018, however, owing to increased inflation, but we expect that to be offset by reduced GDP growth and a narrower output gap. 

Uncertainty about the next Government’s economic policy 

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. There is considerable uncertainty about this part of the forecast, as the lines are still fuzzy as regards Cabinet negotiations. However, our forecast is based on the expectation that the Government will support monetary policy with a conservative stance during the current expansionary period. 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.