Year begins with unchanged policy rate

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 7 February, the next interest rate announcement date. Short-term developments in inflation, falling real interest rates, fiscal easing, and a less favourable composition of GDP growth will probably be key factors in the upcoming policy rate decision, although there are offsetting considerations as well, including slowing house price inflation, a stable ISK, and the prospect of weaker output growth. 
The MPC’s forward guidance will probably be neutral but could conceivably lean towards a tougher tone than has recently been in evidence. For example, the MPC agreed in December that demand pressures in the economy necessitated a tight monetary stance – and potentially an even tighter one if the fiscal stance should ease further. Although the outlook is not for substantially more fiscal easing, it appears to us nonetheless that the stance will be more accommodative this year than the CBI assumes. 

Real policy rate on the decline

By most measures, the real policy rate has fallen steadily since mid-2017. The decline ranges between 0.8% and 1.2%, depending on the metrics used, making for a real policy rate of 1.3-2.0%. In terms of past inflation, the real policy rate has declined by 0.4% since the previous rate decision in December 2017, and in terms of the breakeven rate in the bond market it has fallen by 0.2%. The monetary stance has therefore eased markedly since H1/2017. 

It will be intriguing to discover how the MPC interprets this change in the monetary stance. In general, Committee members appeared relatively satisfied in December, at least according to the minutes of the December meeting. One member expressed the view that there could be grounds for a rate hike at that time. The easing since then will probably strengthen that member’s opinion, and perhaps bring other members on board with it. 

Outlook for more fiscal easing but a narrowing output gap

It emerged at the press conference on the December interest rate decision that public finances had seemingly contributed more to 2017 GDP growth than previously assumed. The budgets released by the country’s largest municipalities and the national budget enacted under the current Government suggest to us that the fiscal stance will be somewhat more accommodative than the CBI projected last November. If the CBI shares our opinion, the MPC will be less inclined to loosen the monetary stance at present. 

On the other hand, our updated macroeconomic forecast indicates that 2018 output growth will be weaker than previously anticipated. The main difference lies in a year-on-year contraction in business investment and weaker-than-expected growth in services exports. As a result, the output gap could narrow more rapidly than the CBI projected in its last Monetary Bulletin. Private consumption and public-sector activity will grow significantly this year, however. 

In sum, the outlook is for slower output growth than previously expected, whereas the composition of GDP growth will be less favourable from an economic policy standpoint. These two factors could have offsetting effects on the MPC’s forthcoming decision.

ISK cruising in calm waters

The ISK has been relatively stable since mid-August. This is interesting, given that most of the capital controls were lifted in Q1/2017 and the CBI has done almost no trading in the foreign exchange market since mid-July. The stability of the ISK indicates the success of the liberalisation process and reflects a reasonably healthy balance between foreign currency inflows and outflows.

In December, the MPC noted with satisfaction that the FX market had been well balanced during the prelude to the December interest rate decision. It stands to reason, then, that the Committee will welcome the continuation of that stability, which tends to mitigate inflation volatility. 

Inflation rises; breakeven rate follow suit

Inflation has picked up somewhat since the last MPC meeting, measuring 2.4% in January 2018, the highest since July 2014. Furthermore, deflation as measured by the CPI excluding housing has tapered off, to 0.9% in January. The outlook is for inflation to remain close to the CBI’s 2.5% target in the near term. In comparison, the CBI’s most recent inflation forecast provided for 2.0% inflation in Q1/2018 and 2.4% in Q2.

 In view of the recently published January inflation figures, the bank will probably revise its last forecast upwards, at least for near-term inflation. Other things being equal, this will discourage the MPC from lowering the policy rate for now. 

The breakeven inflation rate in the market has risen slightly since the last interest rate decision. A large portion of the increase emerged after the January inflation figures were published. Apart from one week in September 2017, the breakeven rate has not risen this fast since Q3/2016. Presumably, the current rise will be a thorn in the Committee members’ side, given how gratified they were in December, when new inflation expectations numbers turned out in line with the target. In this context, it will be interesting to see the newest market expectations measurements, due for publication on Monday 5 February. 

We forecast a rate cut in the coming term 

In our opinion, rising inflation will continue to push the real policy rate downwards in coming quarters, all else being equal. The CBI could decide to expedite a decline in the real policy rate, however, by lowering nominal interest rates moderately as demand pressures in the economy subside and the inflation outlook improves again. The Committee could therefore cut the policy rate by half a percentage point over the next two years, according to our forecast.

 Policy rate forecast for Feb-2018