Policy rate unchanged, in line with forecasts
The MPC decided to keep the Central Bank (CBI) policy rate unchanged, in line with our projections and those of other official policy rate forecasters. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5.0%.
The grounds cited by the Committee for its decision to keep interest rates unchanged are as we expected. The MPC says that rapid growth in economic activity and clear signs of growing demand pressures in the economy call for a tight monetary stance so as to ensure medium-term price stability. A stronger anchor for inflation expectations at target and the appreciation of the króna have enabled the MPC to achieve its legally mandated price stability objective at a lower interest rate than would otherwise have been possible.
Neutral forward guidance again
The forward guidance in the MPC statement continues to be neutral. The Committee stated this morning, as it did in December, that “[t]he monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres.”
The CBI intends to mitigate short-term FX market volatility
Alongside its December decision, the MPC stated that it would not change the CBI’s foreign exchange market intervention policy but would reassess the situation at this month's meeting. In today's statement, the Committee says that there has been somewhat more short-term exchange rate volatility year-to-date than in the previous two years. The statement also says that the aim is to reduce short-term fluctuations in the near term, in line with the objective of mitigating exchange rate volatility. The Committee notes that Bank’s transactions in the foreign exchange market will also take into consideration that there is no longer a need to build up the foreign exchange reserves further and that the risk of a temporary overshooting of the exchange rate during the run-up to capital account liberalisation has diminished in the wake of the recent completion of major milestones in the liberalisation process. This indicates that, in a departure from the practice in recent months, and particularly in the past year, the CBI will not only buy currency for the reserves in the near future but could step up its selling activity if further downward pressures can be discerned in the FX market.
At this morning’s press conference on the interest rate decision, the Governor said that it was now more likely that the CBI would participate in the market on both sides; i.e., it might sell and buy currency in the interbank market in response to short-term fluctuations in the exchange rate. He said that it was important not to interpret this to mean that the CBI considered the exchange rate too low, as the bank’s recent FX market activity has been restricted to the buy side and has therefore leaned against the appreciation of the ISK. He added that the CBI’s particular objective was to mitigate short-term volatility, particularly intraday volatility. In this context, it should be noted that in the forecast published concurrent with today’s interest rate decision, the CBI assumes that the ISK will appreciate in the near future.
When asked, the Governor said this did not signal asymmetric Central Bank response to exchange rate volatility. He noted that the FX reserves might grow, although there is no need to build them up. Neither is the CBI trying to hold the exchange rate at some specific value. If the ISK continues to appreciate and does so gradually, there is less likelihood that the CBI will counteract it by intervening in the FX market than if exchange rate movements are sudden. The Governor added that the CBI has internal rules on intervention but that they are not etched in stone. It is not possible to publish such rules because it is not in the CBI’s best interests to be entirely predictable in its FX market activity, unlike monetary policy, where the bank should be predictable.
Improved inflation outlook
The CBI published an updated inflation forecast alongside today’s interest rate decision. In the bank’s opinion, the inflation outlook has improved slightly since the November forecast, in spite of a widening output gap. The outlook is based, however, on the assumption that wage agreements will not be up for negotiation in the near future. This, in the CBI’s view, is highly uncertain. Domestic inflationary pressures have been offset by low global inflation, the CBI’s forecast of a rise in the exchange rate during the forecast horizon, and a tight monetary stance. Monetary policy has anchored inflation expectations, contained credit growth, and contributed to more saving than would otherwise have occurred. Inflation expectations are broadly in line with the CBI’s inflation target and have declined by ½-1½ percentage points in the past year.
The bank’s inflation forecast is relatively optimistic, with inflation projected at 2.1% this year, 2.5% in 2018, and 2.8% in 2019. It can therefore be said that the CBI expects inflation to be broadly at target for the next three years. According to the CBI’s forecast, this modest inflation rate will stem from continued ISK appreciation averaging just over 3% per year. Pulling in the opposite direction will be continue wage pressures and rising house prices. The rise in the exchange rate will keep inflation in check even though unit labour costs look set to rise significantly over the forecast horizon. The CBI’s forecasting model assumes that the equilibrium real policy rate is 3%. This is subject to considerable uncertainty, however. The bank says that it is aware that the equilibrium rate has been falling both in Iceland and abroad, but that exactly how much is unclear.
Stronger output growth expected
The CBI published its updated GDP growth forecast alongside today’s interest rate decision. The bank has also revised its GDP growth forecast upwards, from 4.5% in November to 5.3% now. In addition, the CBI estimates that growth was much stronger in 2016 (6.0%) than it had projected in November (5.0%). The outlook for 2018 (3.1%) and 2019 (2.6%) is broadly unchanged, however. The upward revision of the 2017 GDP growth forecast is due in large part to increased investment growth, while the revision of 2016 growth stemmed from increased growth in services export growth during the year, tourism in particular. In view of this, the bank projects that the output gap will be wider this year and unemployment lower than it had previously assumed. Although the CBI envisages a continued rise in the real exchange rate, it nonetheless forecasts a sizeable current account surplus averaging 4.4% of GDP per year throughout the forecast horizon. At today’s press conference, the CBI’s Chief Economist said that the forecast implies that the equilibrium real exchange rate is rising. He said that one of the reasons was that terms of trade are improving over the period, Iceland's external position has improved, and export growth is strong. He noted that the bank does not know exactly where the new equilibrium real exchange rate lies but is convinced that it has been rising.