Our forecast: unchanged policy rate on 15 March

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 15 March, the next announcement date, reflecting countervailing effects from a strong appreciation of the ISK, an improved short-term inflation outlook, and reduced uncertainty in the labour market, on the one hand, and swift growth in domestic demand coupled with a steep rise in house prices, on the other. However, the Committee could issue forward guidance opening up the possibility of a rate cut in the near future if the ISK appreciates further and inflation subsides in coming months. We expect these things to materialise and project that the CBI will lower the policy rate by 0.5 percentage points by the middle of this year. If our forecast materialises, the CBI’s key interest rate will be 4.5% in the latter half of 2017. 

Unanimous decision to keep rates unchanged in February

On its last decision date, 8 February, the MPC decided to keep the policy rate unchanged. According to the minutes from that meeting, the Committee voted unanimously in favour of the proposal to keep rates unchanged and did not even discuss other possibilities. As grounds for the February decision, the MPC stated that rapid growth in economic activity and clear signs of growing demand pressures in the economy called for a tight monetary stance so as to ensure medium-term price stability but noted that a stronger anchor for inflation expectations at target and the appreciation of the króna had enabled the MPC to achieve its legally mandated price stability objective at a lower interest rate than would otherwise have been possible. The MPC closed its statement as follows: “Strong growth in demand and unrest in the labour market call for caution in setting interest rates. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres.” 

This last sentence indicates to us that the MPC wants to play it safe before responding to short-term developments in the economy, even though arguments could be made for a rate cut now. In view of the scope of the changes described above, it would be somewhat inconsistent—and unconducive to transparent and predictable monetary policy—if the Committee were to abandon this unanimous support of an unchanged policy rate, neutral forward guidance, and cautious tone concerning future interest rate cuts only a month later. 

ISK appreciation and rapid GDP growth major factors

Developments in the ISK exchange rate have affected MPC decisions in the past, although the impact on the Committee’s most recent decisions has been uneven and not always transparent. Since the last interest rate decision, the ISK has appreciated by 5.8% in trade-weighted terms, and it is now more than 4% stronger than the CBI projected in its last macroeconomic forecast, published in February. The appreciation was extremely rapid in February but has reversed slightly since the beginning of March. Exchange rate volatility has increased dramatically in recent months, as has uncertainty about short-term movements in the ISK. We therefore consider it likely that the MPC will want to see the strengthening trend solidify again before it takes further decisions based on the exchange rate.

Inflation has remained unchanged since the last interest rate decision. It measured 1.9% in February, as it did in the two months beforehand. The breakeven inflation rate in the bond market has fallen slightly over the same period. The five-year breakeven rate is now 2.0%, and the ten-year rate is 2.3%, down from 2.1% and 2.4%, respectively, at the time of the last interest rate decision. The short-term inflation outlook has probably improved somewhat, not least because of the appreciation of the ISK. For instance, IKEA recently announced a 10% average price reduction in response to favourable exchange rate movements. And finally, there are signs that increased competition, both from retail chains opening in Iceland in coming months and from online merchants, has contained various specialty goods prices. The MPC will not have a new CBI inflation forecast in hand this time, however, and will probably choose to exercise caution as regards the changed inflation outlook. 

Just recently, it was announced that the wage agreements between the Icelandic Federation of Labour (ASÍ) and the Confederation of Icelandic Employers (SA) would remain in effect until next year even though one of the premises for them—that worker groups outside ASÍ would not receive large pay increases—had not held. Presumably, the MPC will consider this good news, as it has been quite concerned about uncertainty in the labour market in the recent past. Assuming that wage agreements hold, negotiated pay rises will be much smaller this year than last year, and the cost pressures on the domestic price level will be commensurably weaker. 

As counterarguments to the above, however, there are two main factors that could encourage the MPC to take a more cautious stance than it would otherwise. First of them is GDP growth, which newly published figures from Statistics Iceland (SI) show to have been much stronger (7.2%) in 2016 than the CBI projected (6.0%) in its February forecast. Mitigating this somewhat is the fact that the difference between the CBI forecast and SI’s measurements stemmed mainly from stronger-than-expected growth in services exports and residential investment. As a result, the composition of GDP growth remains highly favourable. Domestic demand grew by 8.7%, which is in line with the CBI forecast, even though GDP growth was stronger than projected. It is worth noting that, in December, the MPC lowered the policy rate in the face of recent GDP growth figures showing (as they do now) unexpectedly rapid growth, arguing that the composition of growth was more favourable than had been anticipated. 

The second caution-inducing factor is house prices, which we expect to be more of a thorn in the MPC’s side, as housing inflation has accelerated steadily in the recent past and real house prices are now rising nearly twice as fast as real wages. This is a radical change from the recent past, when these two variables kept pace with each other fairly reliably. 

We expect the MPC to decide, upon consideration of the aforementioned factors, to wait and see before lowering the policy rate further. The Committee will probably cite strong demand growth and potential uncertainties relating to capital account liberalisation and the ISK exchange rate as grounds for caution in rate-setting. It is quite possible, though, that favourable exchange rate movements in the recent past, reduced uncertainty in the labour market in the coming term, and signs of weaker short-term inflationary pressures will prompt the MPC to open the door to the possibility of a rate cut later in the year. In that case, its forward guidance will probably lean towards signalling a possible rate reduction instead of being neutral, as it has in the recent past.

Two rate cuts in Q2

As before, we expect the ISK to strengthen further as 2017 progresses. If this materialises, inflation could taper off again as summer draws near. In our inflation forecast from February, we assumed that inflation would hold broadly unchanged at the current level for the remainder of the year, but that forecast was based on a somewhat lower exchange rate than now appears likely. Therefore, we consider the uncertainty in that forecast to be concentrated on the downside—i.e., towards lower inflation. We are of the opinion that, if inflation subsides again in coming months as the ISK appreciation takes root, the MPC will have scope to lower the policy rate so as to prevent the monetary stance from tightening still further with a rising real interest rate. We project that the Committee will lower the policy rate by 0.25 percentage points, first on 17 May and then on 14 June. This would bring the CBI’s key interest rate—i.e., the rate on seven-day term deposits—to 4.5%. We then expect the Committee to keep the nominal policy rate unchanged for the rest of the year; however, the real rate will rise steadily over time as inflation picks up.