In November 2022, MPC members voted unanimously to raise the key interest rate. Governor Ásgeir Jónsson’s proposal to raise it by 0.25 percentage points was approved unanimously, albeit with the caveat that Gylfi Zoëga would have preferred a rate hike of 0.5 points.

According to the minutes from the November meeting, MPC members were of the opinion that there were grounds to either hold the key rate unchanged or raise it by 0.25-0.5 percentage points. The arguments in favour of an unchanged rate were given far shorter shrift than the arguments for a rate hike, however.

The MPC’s main arguments in favour of leaving the policy rate unchanged were as follows:

• Although inflation had risen between meetings, there were signs that it would subside.
• The housing market had continued to lose momentum, although it would probably take longer than previously anticipated for it to cool.
• Moreover, there were signs that tension in the labour market had peaked.

Key arguments for a rate hike:

• The economy was still running at a good clip.
• The output growth outlook for 2023 had improved markedly, and the output gap was expected both to be wider in 2023 than previously assumed and to narrow more slowly.
• The outlook was for more rapid growth of domestic demand, partly because disposable income had risen more swiftly than previously projected.
• The MPC considered it cause for concern that underlying inflation had continued to rise and that price increases were so widespread.
• The ISK had depreciated since the MPC’s October meeting, and the global inflation outlook had deteriorated, which would lead to higher imported inflation, all else being equal.
• Inflation expectations were high by all measures and appeared less firmly anchored to the target.
• The inflation risk profile was considered tilted to the upside.
• The real rate was still negative, and in view of the tension in the labour market and the economy, it needed to be higher.

Below is a summary of the factors that will probably affect the MPC’s February decision.

We expect arguments in favour of a rate hike to carry the day this time, although those listed in the right-hand side of the table will doubtless dilute MPC members’ zeal.

The GDP growth outlook has improved

In our newly published macroeconomic forecast, we sketched out a more favourable view of the real economy than we had done previously. In particular, domestic demand – code for consumption and investment – looks set to be stronger in 2023 than we had previously estimated. If the forthcoming macroeconomic forecast in the CBI’s Monetary Bulletin, published concurrent with next week’s interest rate decision, falls along the same lines as our own, it should alleviate Committee members’ concerns about an overly tight monetary stance later this year.

Furthermore, the labour market looks set to remain tight in the coming term, external trade will be less favourable than previously anticipated, and wage inflation will be out of sync with the inflation target this year.

There have been improvements, however, and certain variables show signs that the CBI’s tighter policy stance has begun to bite. One of these is house prices, which fell marginally in Statistics Iceland’s (SI) most recent measurement, after soaring for most of last year. Twelve-month house price inflation now measures just over 18%, after having peaked at nearly 25% in mid-2022. Other indicators also suggest that the housing market is rebalancing. These include the average time-to-sale, the share of homes selling at a premium on the asking price, and the total number of properties on the market.

Moreover, the MPC can take some comfort from payment card turnover numbers, which give an important indication of short-term developments in private consumption. After a historically rapid increase in H1/2022, real growth in card turnover has slowed considerably and, in fact, was nearly flat in December. On the other hand, consumption could spike in the early months of 2023, spurred by the hefty pay rises in the recent private sector wage agreements – which, additionally, were retroactive to November 2022.

Inflation is proving persistent

Since the MPC announced its November interest rate decision, inflation has developed more unfavourably than most observers expected, including the CBI itself. Its November forecast assumed that inflation would average 8.5% in Q1/2023, but headline inflation measured 9.9% in January, making it more likely that the average for the quarter will be just over 9%. Fortunately, the outlook is still for a fairly brisk decline in inflation further ahead: according to our macroeconomic forecast, it will average 7.6% in 2023, 4.5% in 2024, and 2.8% in 2025.

But the fact that underlying inflation has risen by most measures and that inflation is ever more widespread will probably be of greater concern to the MPC. For example, all of SI’s key measures of the general consumption price level have risen, and the share of subcomponents that have risen far more than is consistent with the inflation target has increased as well. The ISK – among the Committee’s worries at the time of the November meeting – has depreciated somewhat since then. On the other hand, there are signs that inflation abroad has peaked, and the ISK has picked up a bit after its uninterrupted slide stretching back to last summer.

.. and inflation expectations remain elevated

Inflation expectations are still high by most measures and are out of line with the CBI’s 2.5% inflation target. It should bring some relief to the MPC, however, that expectations have not risen further in recent months and have even started to ease by some measures. For example, according to the CBI’s most recent market expectations survey, market agents’ long-term inflation expectations fell between surveys, although short-term expectations did not. On that score, however, it is worth noting that the CBI survey was conducted before the publication of the January CPI, which showed higher inflation than was generally expected at the turn of the year.

Both the long-term breakeven inflation rate in the bond market and households’ and businesses’ expectations appear to have been relatively stable in the recent term, after surging during the period beforehand. On the other hand, the short-term breakeven rate has risen markedly since the MPC’s November decision.

The MPC must surely be concerned about how high long-term inflation expectations still are, and members are likely to bear this in mind when setting interest rates next week.

Real rates are rising

The real rate – both real indexed Treasury bond yields and forward-looking measures of the real policy rate – has generally risen since mid-2022. Our estimates indicate that the real policy rate is now around 1% in terms of the average of forward-looking measures apart from household expectations, according to which it is still negative.

In November, the MPC pointed out that the real rate would have to rise, in view of the tension in the labour market and the economy more generally. Clearly, there is still progress to be made on that front, and the MPC is likely to base its upcoming decision on that rationale.

Rate hikes are probably coming to an end

In spite of everything, however, we are of the opinion that the monetary tightening phase is coming to a close after the steep rate hikes dating back to spring 2021. The outlook is for a fairly swift drop in inflation this year, and GDP growth appears likely to be more or less in line with growth in potential output. Furthermore, unemployment looks set to inch upwards and wage inflation to ease in coming years, as we explained in our macroeconomic forecast.

In our opinion, whether the MPC raises the policy rate again in March will depend on the size of the rate hike in February. At all events, the outlook is for a policy rate increase of 0.5 percentage points in Q1, bringing the monetary tightening episode to an end at 6.5%.

Further ahead, however, the policy rate will probably fall again, perhaps starting in Q4/2023 – provided that inflation develops in line with our forecast. Thereafter, the policy rate will fall gradually as inflation eases and the economy becomes better balanced. We project the policy rate to average 6.4% in 2023, 5.3% in 2024, and 4.3% in 2025.

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