Policy rate cut — in the face of most forecasts

The Central Bank (CBI) Monetary Policy Committee (MPC) took the market by surprise this morning when it announced its decision to lower the CBI’s policy rate by 0.25 percentage points. The rate cut takes effect immediately. Forecasts ranged from no change to a 25-point reduction, with the majority of forecasters (ourselves included) in the former camp. The domestic market has responded strongly thus far, with nominal bond yields falling by 0.13-0.22 percentage points. Indexed yields have also fallen, but less markedly, and domestic equity prices have risen somewhat. 

This is the third interest rate decision of four since mid-year in which the MPC has made a move contrary to most forecasts, giving rise to questions about the transparency of monetary policy. In response to questions at this morning’s press conference, the Governor said that transparency was desirable but not always possible, especially now, when the CBI’s policy rate was being fine-tuned. 

ISK appreciation creates scope 

According to this morning’s MPC statement, “[i]nflation expectations appear more firmly anchored to the target than before, and the monetary stance has tightened to some extent, through the appreciation of the króna. This gives the MPC some scope to lower nominal interest rates now.”

The ISK has appreciated by 1½% in trade-weighted terms since the Committee’s last meeting and is already above the average the CBI has projected for 2017. In this context, it is worth noting that between the interest rate decision on 5 October and the following one, on 16 November, the ISK appreciated by 4.6%, yet the MPC decided to keep the CBI’s interest rates unchanged in November. It is also interesting that the lion’s share of the appreciation that the CBI had expected to take place over a period extending well into 2017 had already occurred when the Committee made and announced its November decision. In view of this, it can be said that the MPC is responding now to the conditions supporting a rate cut that were largely in place at the time of its last decision, when we projected a 0.25-point reduction. According to recent MPC statements, the Committee appears to have been a bit undecided about whether exchange rate developments are in line with its expectations or whether they justify a change in the monetary stance, as was the conclusion this time. 

Rate-cut camp swells its ranks

According to the minutes from the MPC’s November meeting, two of the Committee’s five members wanted to lower interest rates at that time, reflecting the uncertainty surrounding the decision. At this morning’s press conference, the Governor said that the November decision had represented a delicate balance and could have turned out different than it did. It appears, then, that the two members of the rate-cut contingent have strengthened their following this time. Even so, we think it unlikely that today’s decision was unanimous, as developments since the November decision have not been so momentous as to have called forth a change of attitude among all MPC members. 

Deterioration of external conditions goes under the radar

In today’s statement, the MPC mentions that inflation is below target and has remained there in spite of steep pay hikes and rapid growth in demand. It also says that favourable external conditions, the appreciation of the ISK, and a tight monetary stance have anchored inflation expectations.

But it makes no mention of the recent erosion of external conditions as represented by the rise in oil prices, inflation expectations, and long-term interest rates. When asked about this at the press conference, the Governor said that conditions had indeed deteriorated but were still very favourable and that some of the recent erosion had been included in the CBI’s November forecast. 

Forward guidance unchanged 

The MPC's forward guidance is unchanged since November. The Committee remains neutral about its next step, saying that strong demand growth and uncertainty about the next Government’s economic policy, together with unrest in the labour market and uncertainty about the impact of the next steps towards capital account liberalisation, “call for caution in interest rate setting. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres.” We project that the Committee will lower the CBI’s interest rates further in the first half of 2017.