Our forecast: unchanged policy rate on 17 May

We forecast that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to keep the bank’s policy rate unchanged on 17 May, its next decision date. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5%. As grounds for its decision, we expect the Committee to say that even though inflation and inflation expectations are at target, strong domestic cost increases – particularly wages and house prices – together with rapid growth in economic activity and a widening output gap call for an unchanged policy rate. 

The forward guidance in the MPC’s most recent statement, published at the time of the last interest rate decision, was neutral, as it had been previously. According to the minutes from the last interest rate decision meeting, members agreed that in the coming term, the monetary stance would be determined by economic developments and actions taken in other policy spheres. We expect the Committee to continue in this vein and give neutral forward guidance in its next statement as well. In this context, it is worth noting that none of the MPC members considered a change in the policy rate warranted at its last meeting, held on 15 March, and Governor Már Guðmundsson's proposal to keep it unchanged was therefore approved unanimously. 

ISK virtually unchanged since last interest rate decision 

The ISK has appreciated by nearly 1% in trade-weighted terms since the March decision. It has fluctuated a bit in the interim, particularly during the period just after the authorities announced the removal of capital controls in March. In April, however, the volatility subsided, and the foreign exchange market appears to be adjusting to the changes associated with capital account liberalisation.

Concurrent with the upcoming interest rate decision, the CBI will publish a new macroeconomic and inflation forecast. Its last forecast was updated at the time of the 8 February interest rate decision. The ISK has appreciated by nearly 5.3% since the bank published the February forecast. The trade-weighted exchange rate index (TWI) now stands at 156, whereas the CBI had forecast that it would average 162.6 over the course of 2017. In other words, the exchange rate is now 4.2% above the projected average for the year. The TWI has averaged 161.2 points year-to-date; therefore, it can be expected that the CBI’s new inflation forecast will assume a somewhat stronger ISK than was provided for in February. All else being equal, this will improve the inflation outlook somewhat. 

Signs of rapid GDP growth so far this year 

The CBI will publish its new GDP growth forecast alongside the policy rate decision. Since the publication of the bank’s February forecast, GDP growth figures for 2016 have been published, showing a growth rate of 7.2% for the year, the strongest growth rate yet measured in the current upward cycle. It is somewhat above the CBI’s forecast for the year as a whole, as the bank had projected it at 6.0% in February. The figures suggest that the output gap is widening somewhat more rapidly than the CBI assumed in that forecast.

It is well to bear in mind that last year’s GDP growth figures had been published by the time of the March interest rate decision and were taken into account by the MPC when it decided to hold rates unchanged. According to the minutes from that meeting, members agreed that, although GDP growth had been export-driven to a considerable degree, it had been well in excess of long-term potential and had begun to strain domestic resources. Committee members therefore considered it likely that the output gap had grown wider than had been forecast in February and would continue to grow in spite of countervailing effects from labour importation.

Indicators imply continued strong growth thus far in 2017. For example, total hours worked rose by 3.5% year-on-year in Q1/2017, which is in line with developments in 2016. Furthermore, this year’s increase stemmed from the same cause as last year’s: it was due entirely to a rise in the number of employed persons (+3.9%), as the number of hours worked declined (-0.3%). The numbers suggest that output growth was quite robust in the first quarter of 2017. The CBI projected 2017 GDP growth at 5.3% in its February forecast. 

Inflation and inflation expectations still at target 

Inflation measured 1.9% in April, up from 1.6% in the preceding month. It now measures the same as it did at the time of the March interest rate decision – and actually, the same as it did between December 2016 and February 2017. The monetary stance in terms of the spread between past inflation and the CBI’s effective policy rate has remained unchanged since the last interest rate decision. 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.

In Q1/2017, inflation measured 1.8%, slightly below the CBI forecast of 1.9%. The bank has projected Q2 inflation at 2.0%, whereas we expect it to measure 1.9%.

The CBI will also publish a new inflation forecast on the upcoming interest rate decision date. Our current inflation forecast for coming quarters is somewhat lower than the bank’s last forecast. One of the main reasons for the difference between the two is that we expect the ISK to be stronger than the CBI does. The inflation outlook for the coming year is somewhat cloudier in our forecast, however, as we expect the ISK to soften slightly, while the CBI expects it to keep strengthening. We assume that the CBI’s new forecast will provide for slightly lower near-term inflation than the previous one did. On the other hand, the bank may well project higher inflation through 2018 than it did in February, owing in part to the exchange rate, but also due to a wider output gap than was expected then.

It is worth noting that because of GDP growth, exchange rate developments, and other factors, MPC members’ inflation expectations may well have differed from those implied in the bank’s inflation forecast at the time of the last interest rate decision. In this context, it is also appropriate to remember that inflation expectations have been rising in the recent term. In terms of the spread between indexed and non-indexed bond market rates, for example, they have risen since the last interest rate decision. Furthermore, corporate inflation expectations according to the Gallup survey carried out in February among executives from Iceland's 400 largest firms have risen to the target. Executives expect inflation to average 2.5% over the next twelve months, an increase of 0.5% from the autumn 2016 survey, and they project it at 3.0% in two years’ time, the same as in the last survey. 

We expect a 0.25-point rate cut in Q3/2017 

We expect the MPC to decide to lower the CBI’s interest rates by 0.25 percentage points in Q3. In August, the bank will publish an updated inflation and GDP growth forecast. We expect that the ISK will have appreciated somewhat 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.

As usual, the ISK is the main uncertainty in our medium-term policy rate forecast, and we still expect it to appreciate until the last quarter of this year. As before, we assume that the exchange rate will fall gradually over the latter part of the forecast horizon, as the trade surplus narrows and the high real exchange rate makes its presence felt.

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.