Our forecast: Unchanged policy rate on 29 August

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to hold the policy rate unchanged on 29 August, the next interest rate decision date. The bank’s key rate will therefore remain 4.25%. If our forecast materialises, this will be the seventh time in a row that the MPC has kept CBI interest rates unchanged. 

It will be more challenging for the MPC to choose the most appropriate monetary stance this time than it generally has been in the recent term. For one thing, inflation and inflation expectations have risen. As a consequence, MPC members will probably have to give more consideration to whether monetary policy credibility is under threat. On the other hand, it appears that some parts of the economy will lose momentum more quickly in coming quarters than was expected earlier in the year.

The forward guidance from the Committee will probably be neutral, as it has been recently. Inflation has picked up, and inflation expectations have risen in the past few months. The ISK has been stable, however, and indicators imply that tensions in the labour market and the economy as a whole are receding somewhat. The real policy rate has fallen in the recent past, but the interest rate differential with abroad remains sizeable.

Modest rate cut probable during the coming year

In our opinion, rising inflation will continue to push the real policy rate downwards in coming months, all else being equal. But given the reasonably favourable inflation outlook and the expectation that the economy will slow down a bit over time, it is not impossible that the CBI will lower the policy rate further ahead, as demand pressures subside and the inflation outlook remains stable. A nominal policy rate cut of 25-50 points in 2019 is therefore a distinct possibility, in our opinion. 

If inflation rises significantly above target in the coming year, however — due to large wage rises, continued pressure in the housing market, and/or a depreciation of the ISK — the CBI will hardly lower the policy rate further. It might even decide to signal the possibility of rate hikes as the winter progresses.

Islandsbanki Research policy rate forecast