Unchanged policy rate on 15 November?

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 15 November, the next announcement date. If our forecast materialises, the CBI’s key interest rate will remain 4.25%. In our opinion, the decline in the real policy rate – triggered by higher inflation and a rising breakeven inflation rate – at a time when a relatively tight monetary stance is needed, together with uncertainty about the fiscal stance and short-term developments in the labour market, will tend to outweigh indicators of weaker GDP growth and a calmer housing market, a more stable ISK, and a fairly favourable medium-term inflation outlook. 

That said, it is difficult to determine the MPC’s priorities at present. The Committee’s last statement and minutes suggest a considerable dove-like tendency among its members, and the possibility of a 25-point rate cut on 15 November cannot be excluded. 

The forward guidance in the MPC’s October statement was neutral, as has been the case for the past year. The MPC’s forward guidance has been of little use in the recent past, as it has provided limited or no signalling of the Committee’s past five rate reductions. In addition, factors such as political uncertainty and exchange rate developments seem to have significantly differing impact on interest rate decisions from one time to another. 

All else being equal, when the predictive value of forward guidance diminishes, uncertainty about medium-term developments in monetary policy will increase, giving rise to more volatile interest rate expectations and long-term interest rates than is desirable. An example of this is the unexpected rate cut in early October, which caused a noticeable drop in bond yields. In our view, it would be better for the efficacy and transparency of monetary policy if interest rate changes were prepared more often than not with clear forward guidance. Had this been done in October (either with a clear indication in August of a potential rate cut or with an unchanged policy rate in October and signalling of an upcoming reduction), the market’s response would most likely have been more moderate and more evenly spread over the autumn months. 

Declining real policy rate

Unlike the rate cut in the first half of this year, which was intended primarily to keep the real policy rate from rising due to declining inflation and inflation expectations, the one in October was expressly intended to lower it. By most measures, the real policy rate changed little in H1/2017. Since mid-year, however, it has fallen by just over a percentage point in terms of the breakeven inflation rate on Treasury bonds, and by about 0.6 percentage points in terms of past inflation. By other measures as well, it fell markedly, as can be seen in the chart below.

Beginning with the early October interest rate decision, the real policy rate has fallen by a good half a percentage point in terms of both the breakeven rate and past inflation. A decline in the real policy rate is normal, given the prospect of diminishing demand pressures in the economy and the past few quarters’ relatively stable inflation expectations. It is also clear to us that the MPC considers a real policy rate of 2.0-2.5% (the September average) the equivalent of a tight monetary stance and is therefore of the opinion that the equilibrium rate is currently lower than that. 

It is more questionable whether the Committee will think it warranted to pull in the direction of this recent decline in the real policy rate by lowering nominal interest rates in November – at least in the absence of more explicit signs of the direction fiscal policy and the labour market are taking, a more balanced housing market, a further slowdown in economic activity, or some combination of these factors.

Is political uncertainty important?

The Parliamentary elections are now over, but the October interest rate decision was taken shortly after the Government fell and new elections were announced. Nevertheless, the MPC was not overly concerned about political uncertainty at the time and even surmised that it could put a damper on domestic demand. It was also mentioned, however, the post-election fiscal stance provided grounds to keep the policy rate unchanged. This is a major shift in the MPC’s position on such uncertainty, which until then had most often been a thorn in the Committee’s side and had been touted as a valid reason for caution in setting interest rates. In this context, the following excerpt from an MPC statement issued a year ago is a clear example. Then, as now, the election results were in but a working coalition had yet to be formed (our bold-faced emphasis): 

The MPC’s decision to keep interest rates unchanged is taken upon consideration of the Bank’s current forecast and the Committee’s risk assessment. This includes, in particular, the uncertainty about the fiscal stance, which has eased in the past two years and remains uncertain because it is unclear at present what the next Government’s economic policy will be.”

It is difficult to conclude that stable inflation expectations alone suffice to explain this change in the MPC’s assessment of the importance of political uncertainty in its decisions. This is one of the reasons why it is difficult these days to parse the Committee’s decisions – and, by extension, the next steps monetary policy will take.

ISK stable since early October

The ISK has been virtually unchanged since the early October interest rate decision. Actually, it has fluctuated within a narrow range ever since the beginning of August, following a sudden depreciation in June and July. The exchange rate is also in line with the projected September-December 2017 average according to the CB’s last forecast. 

At the beginning of October, the MPC noted that if the ISK should stabilise at the current level, it was unlikely that exchange rate developments would push inflation upwards in the near term. The past month’s exchange rate developments should therefore give the MPC cause to ease the monetary stance, if anything, although they are unlikely to be of pivotal importance to the upcoming interest rate decision. 

GDP growth eases, while private consumption surges 

At the time of the last interest rate decision, the MPC noted that clearer signs of reduced demand pressures in the economy provided the scope to lower interest rates. The Committee mentioned other factors as well: GDP growth in H1/2017 had been below CBI projections, growth in tourism had eased, executives had reported dwindling optimism in the Gallup sentiment survey, the year-on-year rise house prices had lost momentum, and labour shortages had diminished. As a result, the adjustment to a sustainable GDP growth path was quicker than had been expected, and the inflation target could be achieved with a lower real interest rate. 

Various subsequent developments support this analysis. According to the October CPI, house prices declined slightly, for the first time since June 2015, and the most recent figures from the tourism industry indicate a clear slowdown in growth. In addition, there are signs that business investment growth has been more sluggish recently, and the Gallup Consumer Confidence Index has declined in the past few months. 

Even so, there are few signs as yet of a slowdown in private consumption growth. Payment card turnover figures for Q3 indicate a growth rate similar to the 8.3% measured in H1. The composition of GDP growth is therefore becoming less favourable, a factor that the MPC has often emphasised no less than the actual rate of growth. For some reason, though, the Committee saw no reason to voice concerns about this in its October interest rate decision.

Inflation rises, but 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 marginally since the last policy rate decision. The five-year breakeven rate has risen from 2.7% to 2.8% and the ten-year rate from 3.0% to 3.1%. The breakeven rates still broadly reflect inflation expectations consistent with the inflation target, after adjusting for uncertainty about long-term nominal rates. 

In October, inflation turned out quite a bit higher than had been forecast, owing in particular to an abrupt rise in food prices. The CPI rose by 0.5% during the month, raising twelve-month inflation from 1.4% to 1.9%. The October measurement sent mixed messages to the MPC about underlying developments. On the one hand, the uptick in food prices was uncomfortably at odds with the Committee’s opinion that underlying inflation appeared to be subsiding. On the other hand, the slight drop in imputed rent accorded well with the MPC’s expectation that house price inflation could slow down suddenly. 
The CBI will publish a new inflation forecast concurrent with the 15 November interest rate decision. It is not unlikely that this forecast will be somewhat more upbeat about the inflation outlook than the August forecast, which assumed that inflation would peak at 3.2% in Q3/2018 and then taper off towards the target. Our preliminary forecast for the coming term somewhat resembles the CBI’s August forecast, except that in view of the October CPI measurement, we expect a faster rise in inflation. On the whole, the inflation outlook appears favourable, although rising inflation will dilute the monetary stance somewhat in coming quarters, all else being equal. 

Interest rate differential with abroad narrows

The long-term interest rate differential with abroad has narrowed slightly since the last policy rate decision. The spread on 10-year Treasury bonds is now 4.6% against the euro, 3.6% against the pound sterling, and 2.6% against the US dollar, down from 4.8% against the euro, 3.9% against sterling, and 2.9% against the dollar at the beginning of October. The change stems primarily from falling long-term Icelandic Treasury bond yields in the wake of the October policy rate cut.

The Bank of England (BoE) raised its key interest rate last Thursday, for the first time in a decade, thereby joining the US Federal Reserve in ushering in a tightening phase, although the BoE has signalled that its monetary tightening will take place gradually. Short-term interest rates abroad will therefore remain low in the coming term, and the interest rate differential will be correspondingly wide unless Iceland lowers its policy rate.

We expect rate cuts in 2018 

Rising inflation will push the real policy rate downwards in coming months, other things being equal, and we expect the CBI to hold the effective policy rate unchanged in the near term, so as not to accelerate the decline in the real rate. We think, however, that developments 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. Over the course of next year, as inflation stabilises and the output gap shrinks further, the scope for a rate cut could develop, bringing the real policy rate down towards 1% by end-2018. After that, there is nothing to indicate a change in the policy rate in either direction for the remainder of the forecast period (through end-2019), but it need hardly be mentioned that uncertainty about interest rate developments increases further out the horizon.