Policy rate lowered, neutral forward guidance

The Central Bank (CBI) Monetary Policy Committee (MPC) decided today to lower the policy interest rate by 0.25 percentage points. Most analysts expected a rate cut, although forecasts ranged between no change (including our own) and a 0.25-point rate cut. 

Neutral forward guidance

The forward guidance in today’s MPC statement is neutral as regards the Committee’s next moves. According to the statement, “[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 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 is repeated verbatim from the statement accompanying the MPC’s last decision, in March.

Domestic pressures play tug-of-war with ISK appreciation and low global inflation

In today’s statement, the Committee says that demand pressures in the economy are growing but that the ISK appreciation and low global inflation offset domestic inflationary pressures, with the result that headline inflation now measures 1.9%, as it has more or less done over the past six months.

The MPC notes that there are clear signs of increased demand pressures in the economy, calling for a tight monetary stance so as to ensure medium-term price stability. The Central Bank’s real interest rate has risen slightly since the MPC’s last meeting, and the ISK appreciation contains demand.

Clearly, the past few days’ steep rise in the exchange rate has made an impact on the interest rate decision. The ISK has appreciated by nearly 3% in a single week, yet by the middle of last week it had only appreciated by about 1% since the February interest rate decision .

Stronger growth, increased demand pressures, and current account surplus

The CBI now projects much stronger GDP growth in 2017 than it did in its last forecast, from February: 6.3% instead of the previously projected 5.3%. It has also revised its 2018 GDP growth forecast upwards from 3.1% to 3.5%, although the 2019 forecast of 2.5% is broadly unchanged since February. Increased growth this year is due primarily to much more rapid export growth than was forecast in February, particularly in the tourism sector. Offsetting this, the CBI projects more rapid import growth, although it will be outpaced by exports. For 2018, however, more rapid growth in domestic demand – especially private consumption – is the main reason output growth is forecast to be stronger than previously projected.

The bank now expects the ISK to be much stronger over the forecast horizon than it assumed in February. It projects the trade-weighted exchange rate index (TWI) at an average of 157.0 points in 2017, as opposed to 162.6 in the previous forecast. The forecast for 2018 is 148.2 (154.2 in the previous forecast), and for 2019 it is 147.4 (152.4). This change in assumptions is presumably one of the main reasons the CBI now forecasts 2017 inflation at 1.9% (previously 2.15) and 2018 inflation at 2.2% (2.5%). On the other hand, the bank expects inflation to measure 3.3% in 2019 (previously 2.8%). In spite of a higher real exchange rate and a wider output gap than in the previous forecast, the CBI now expects a larger current account surplus in 2017-2019 (5.9% of GDP, on average) than in its previous forecast (4.4% of GDP).

Actually, the CBI considers the ISK appreciation to be primarily a reflection of the economy’s adjustment to changed circumstances. The equilibrium real exchange rate has therefore risen significantly, owing to factors such as an improved external position, more favourable terms of trade, and the burgeoning tourism industry. The bank says that the current ISK exchange rate is close to equilibrium. It estimates that if the exchange rate had been unchanged since 2014, inflation would have risen above target as early as 2015 and the policy rate would have been 3.5 percentage points higher in 2016 than it actually was.

When asked about developments in the housing market at this morning’s press conference on the interest rate decision , the Governor said that the recent surge rise in house prices was due mainly to structural factors rather than an accommodative monetary stance. On the other hand, it was worth examining whether there was need for a targeted response to the increased financial system risk concurrent with rapidly rising prices, although this fell outside the scope of the MPC’s activities.

According to the Governor, the possibility that upcoming wage negotiations might entail pay increases in excess of the level consistent with the SALEK agreement poses risks to the inflation outlook, but the CBI’s forecast assumes that the agreement will hold. At this stage, he said, there was no reason to base the bank’s forecast on the assumption that the agreement would fail.