Our forecast: unchanged policy rate on 23 August

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 23 August, the next announcement date. A deteriorating inflation outlook – and the probability of a more accommodative monetary stance – stemming from the ISK depreciation since early June will be the major determinant, in our view. Yet there is a need for some monetary restraint, as the economy is quite robust, wages and house prices have risen rapidly, and it does not appear as though fiscal policy or the labour market will support economic policy to any marked degree in the near term. 

The MPC’s forward guidance will presumably remain neutral, as it has been in the recent term, but the experience of recent quarters tells us that forward guidance has relatively limited informational value when the monetary stance is close to the level deemed appropriate by the MPC. This has been the case recently, and the minutes of the MPC’s last meeting show that a majority of Committee members viewed a rate cut primarily as a way to adjust for the real rate increase caused by declining inflation.

The doves in the Committee, who would have supported a larger rate cut than was ultimately decided in June, can still find grounds for a rate reduction, however. Among them are inflation, which is still below the CBI’s 2.5% inflation target; inflation expectations, which have remained moderate; the long-term interest rate differential with abroad, which has widened; and the output gap, which will probably be narrower in the coming term than previously thought. As a result, it is not impossible that the MPC will decide to lower interest rates in the latter half of this year, either in August or later. 

ISK significantly weaker since the last interest rate decision

Since the MPC’s June interest rate announcement, the ISK has weakened by nearly 10% in terms of the trade-weighted index (TWI). It has fallen by nearly 9% since May, when the CBI published its last inflation forecast.  The TWI now stands at 165 points, whereas the CBI forecast in May that it would average 157 over the course of the year. In other words, the ISK is now almost 5% weaker than the projected average for the year. The TWI has averaged 158.7 points in 2017 to date.

In May, the CBI projected that the ISK would be somewhat stronger in 2018 (TWI 148.2) and 2019 (TWI 147.4) than in 2017. It now appears less likely than before that this forecast will be borne out. The recent weakening of the ISK does not appear to be a thorn in the bank’s side, however, as it has only intervened in the foreign exchange market three times since early June in order to halt a spiral. On the other hand, we expect the CBI’s new forecast to provide for a weaker ISK than the last forecast did, which would tend to imply higher inflation, other things being equal.  

Signs of weaker GDP growth so far this year  

The CBI will publish its new macroeconomic forecast concurrent with the next interest rate decision. Since the last forecast, published in May, GDP figures for Q1/2007 have been released. GDP growth measured 5.0% during the period, as opposed to last year’s average of 7.2%.  It was also below the CBI’s last forecast for 2017 as a whole (6.3%). 

Indicators imply that growth in the past few months has been similar to that in Q1. Total hours worked rose by 2.0% year-on-year in Q2, the slowest rate of increase since Q4/2014. The main reason for this is the increase in the number of employed persons (1.8%), as average hours worked per week rose by 0.2%.  Furthermore, goods imports and exports have both slowed down YoY thus far in 2017. It is possible that the CBI will revise its 2017 GDP growth forecast downwards in comparison with the May forecast, but we still expect it to project a robust growth rate. As a result, the output gap provided for in the August forecast could be narrower than in the previous forecast, although we expect it to remain a factor in the CBI’s assumptions for upcoming quarters. 

Inflation and inflation expectations still close to target

The breakeven inflation rate in the bond market, measured in terms of the spread between indexed and nominal bond market interest rates, has risen markedly since the last policy rate decision. The five-year breakeven rate has risen from 2.1% to 2.5% and the ten-year rate from 2.4% to 2.9%. That said, the breakeven rate still reflects inflation expectations in the realm of the CBI’s inflation target. The same is true of market agents’ inflation expectations. According to the newly published results of the CBI’s market expectations survey, participants expect inflation to average 2.5% over the next five years. This is a slight reduction in comparison with the last survey, in spite of a notable drop in the exchange rate. The results will probably be quite satisfactory to the MPC, as they could indicate that medium-term inflation expectations are less susceptible to short-term exchange rate volatility than before. 

Inflation measured 1.7% in Q2, slightly below the CBI's May forecast of 1.9%.  In July it measured 1.8%. Inflation is now broadly where it was at the time of the May (1.9%) and June (1.7%) interest rate decisions. The monetary stance in terms of the spread between past inflation and the CBI’s effective policy rate has remained virtually unchanged since the last interest rate decision. It is also broadly unchanged in terms of market agents’ inflation expectations. In terms of developments in the breakeven inflation rate in the market, however, the monetary stance has eased somewhat over this period. 

The CBI will publish a new inflation forecast on the upcoming interest rate decision date. In view of the weaker ISK, it is reasonable to expect the new forecast to be more pessimistic than the May forecast, which provided for below-target inflation through mid-2018. Our most recent inflation forecast assumes that inflation will rise in coming quarters and will be somewhat above target in 2018 and 2019. 

If the CBI’s inflation forecast is revised in line with our forecast, it will entail a declining real policy rate in terms of 12m trailing inflation, assuming an unchanged effective policy rate. Whether inflation expectations and the breakeven inflation rate rise accordingly – and whether the real policy rate will decline by that measure in the coming term – depends on the credibility of monetary policy and confidence in the foundations of the ISK. 

We expect a small rate reduction in 2018 

In our opinion, the decline in the real policy rate in coming quarters will go more or less hand-in-hand with reduced need for a tight monetary stance as the economy slows down and the output gap narrows. It could be, however, that the CBI will want to see the monetary stance ease somewhat faster than the decline in real policy rate due to increased inflation and rising inflation expectations further ahead, particularly if the latter proves less sensitive than before to a temporary spike in inflation. It is therefore likely that the bank will lower the policy rate sometime next year, although there is little prospect of a large reduction from the current level unless the ISK strengthens significantly and inflation subsides again. After that, there is nothing to particularly indicate a change in the policy rate in either direction for the remainder of the forecast horizon (through end-2019), but it need hardly be mentioned that uncertainty about interest rate developments increases further out the horizon.