Policy rate unchanged – in line with our forecast

The Central Bank (CBI) Monetary Policy Committee (MPC) has decided to keep the policy rate unchanged, in line with our forecast. Official forecasts ranged from no change to a 0.25 percentage point rate cut. The Committee’s rationale for its decision to keep rates unchanged is broadly as we expected: stronger-than-anticipated GDP growth, signs of continued rapid growth in demand in 2017, and uncertainty about near-term exchange rate developments in the wake of capital account liberalisation, on the one hand, and reduced uncertainty in the labour market together with the appreciation of the ISK since the MPC’s last rate-setting meeting, on the other. 

Markets have reacted strongly to the decision this morning. Nominal bond yields rose sharply at the opening of the markets, but the rise has reversed. Bond market turnover has been strong as well. The ISK appreciated by just under a percentage point this morning, but it is unclear how much of this is due to the interest rate decision, as the latest liberalisation measures are only a few days old. 

Uncertainty about impact of liberalisation

The MPC says it is too early to predict the economic impact of the most recent steps in the liberalisation process. It also notes the possibility that a better balance will develop between foreign exchange market inflows and outflows but adds that short-term volatility could increase, as appears to have happened in the past few days. The Committee also stresses that the CBI will continue to take action to mitigate short-term exchange rate volatility when conditions warrant it.

At this morning's press conference on the interest rate decision, it emerged that the MPC will focus more on the spread between domestic and foreign interest rates in its upcoming decisions, as the impact of the spread on inflation has increased in the wake of liberalisation. 

Continued neutral tone

The MPC has maintained the neutral tone in its forward guidance, as it has in recent interest rate decisions. The Committee notes that “a firmer anchor for inflation expectations at target and the appreciation of the króna have enabled it to achieve its legally mandated price stability objective with a lower interest rate than would otherwise have been possible. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres.” This part of today’s statement is a verbatim repeat of the 8 February statement.

The Governor said at the above-mentioned press conference that he does not consider it a given that the ISK will appreciate in the near term, in part because it is so strong already. He added that as uncertainty about the domestic economy subsides and inflation expectations become more firmly anchored, equilibrium interest rates—nominal and real rates—will continue to fall. He stressed as well that monetary policy had gained credibility, as has been seen in the fact that even relatively wide fluctuations in the exchange rate have not given rise to large changes in the breakeven inflation rate in the bond market. 

Part of a contingency plan to contain the appreciation of the ISK

In response to a question about the Government’s contingency plan to mitigate the appreciation of the ISK, which was mentioned at the Government and CBI’s press conference on liberalisation this past weekend, the Governor said he could not give information about specific aspects of it and that the plan itself was not necessarily fully formulated. The CBI could conceivably participate in it, however. He said that if tighter fiscal policy were a part of that plan, it could enable the CBI to maintain lower interest rates than would otherwise be feasible. If the Government is dissatisfied with the appreciation of the ISK, it could take action aimed at the root of the problem, such as with taxation and access controls in the tourism sector, which has played a major role in the appreciation recently. If measures of this type were part of the package, he said, they could have a decisive impact on the ISK further ahead. 

We expect an interest rate cut

As we said in our policy rate forecast ahead of today’s decision, we expect the ISK to continue appreciating through most of this year. Our new inflation forecast provides for disinflation as the year progresses, not least because of that appreciation. We think that if inflation subsides again in coming months as the ISK appreciation takes hold, 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 twice 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.