Our forecast: unchanged policy rate on 8 February

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 8 February, 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, the recent depreciation of the ISK and strong demand growth call for an unchanged policy rate. 

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

The ISK has weakened markedly since the last interest rate decision 

Since mid-December, the ISK has depreciated by about 4% in trade-weighted terms. This is a reversal of the trend from previous months, where the ISK strengthened between rate-setting meetings throughout 2016.

It is particularly striking in view of the fact that at the MPC’s December meeting, the main argument in support of a rate cut was that the ISK had strengthened by 1.5% since the previous meeting. In the minutes to the December meeting, it was stated that the exchange rate was already above the projected 2017 average according to the Bank’s November forecast. At that time, Committee members were of the view that the medium-term inflation outlook had probably improved even more than was assumed in the forecast. Some members were therefore of the opinion that there was scope to lower nominal interest rates, although various uncertainties mentioned at the time of the previous interest rate decision still existed. Four members voted in favour of the Governor’s proposal to lower the policy rate by 0.25 percentage points, while the fifth voted against, preferring to hold the policy rate unchanged.

The króna has depreciated in the recent term, in part because of transitory factors such as the fishermen’s strike, seasonal fluctuations in tourism-generated foreign exchange revenues, and a temporary increase in foreign currency outflows due to increased freedom of movement of capital. The Committee is likely to consider these factors. On the other hand, the Central Bank has dramatically reduced its once-hefty foreign currency purchases in the domestic FX market; indeed, its purchases in January 2017 were the smallest in a single month since November 2014. In December, the MPC decided not to change its intervention policy but to assess the situation at its next meeting – i.e., the one taking place next week – after the next step towards lifting capital controls on households and businesses had been taken.

The medium-term exchange rate outlook has not changed, in our opinion, and we expect the ISK to appreciate over the course of the year, as the aforementioned downward pressures subside. 

Inflation on the decline and likely to remain below target all year 

Headline inflation has fallen since the December interest rate decision date. It now measures 1.9%, down from 2.1% at the time of the MPC’s mid-December meeting. 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 the appreciation of the ISK and low imported inflation, on the other.

The CBI will publish an updated inflation forecast on the upcoming interest rate decision date. According to the CBI’s last forecast, published alongside the November policy rate decision, inflation was projected to remain close to the target throughout the forecast horizon; i.e., until end-2019.

The exchange rate is now 2.6% below than the averaged assumed for 2017 in the aforementioned inflation forecast. So far this year, it has been, on average, close to the level the bank projected for the year as a whole. The CBI will also publish its new exchange rate forecast, on which the new inflation forecast will be based. The previous forecast provided for modest fluctuations in the exchange rate. We expect the new one to do likewise.

Steep domestic cost price increases and rising house prices will continue to push inflation upwards, although rises in wages and house prices will be more modest this year than in 2016, according to our forecast. Offsetting these increases will be the appreciation of the ISK over the course of the year, although we expect it to be less pronounced than in 2016. Rising inflation abroad will also exacerbate inflationary pressures in Iceland.

According to our most recent inflation forecast, inflation will remain below the CBI’s target well into 2018. This implies slightly lower inflation than was projected in the CBI’s November forecast. However, we expect inflation to rise somewhat in 2018, overtake the target around mid-year, and exceed the CBI’s forecast marginally. On the whole, we do not expect the CBI’s new inflation forecast to entail substantial changes from the November forecast. 

Year-2016 GDP growth above CBI forecast 

Alongside the upcoming policy rate decision, the CBI will publish its updated GDP growth forecast. Since the publication of the bank’s November forecast, GDP growth figures for the first nine months of 2016 have been published, showing a growth rate of 6.2% over that period. This is 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 November forecast. The figures suggest that the output gap is widening somewhat more rapidly than the CBI assumed in that forecast.

According to the minutes from the MPC’s last meeting, the new GDP growth figures were a topic of particular discussion. Attention was given to the fact that not only was output growth stronger, but its composition had also changed and grown more favourable, in the MPC’s opinion; i.e., more business investment and less private consumption. Export growth is also turning out to be a stronger driver of output growth than the bank had forecast. We expect the CBI’s new GDP growth forecast to reflect these figures.

In its November forecast, the CBI projected output growth for 2017 at 4.5%. This is slightly below our own forecast of 5.1% for the year. We do not expect the CBI’s new output growth forecast for 2017 to change radically. 

We expect a 0.25-point rate cut in Q2/2017 

We expect the MPC to decide to lower the CBI’s interest rates by 0.25 percentage points in Q2. In May, the bank will publish a new inflation and GDP growth forecast. We expect that the ISK will have begun to appreciate again by that time and that this, together with below-target inflation, will support the Committee’s decision to lower the policy rate. 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 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 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.

Developments in monetary policy will naturally take account of actions taken in other policy spheres. According to the medium-term fiscal strategy presented by the new Government, fiscal policy is expected to tighten, thereby supporting monetary policy in its bid to control inflation. The surplus on general government operations will measure about 1% of GDP this year and rise to 1.6% over the next two years, according to the strategy.