Broad consensus on policy rate cut in October

Members of the Central Bank (CBI) Monetary Policy Committee (MPC) were more strongly in agreement about this month’s policy rate cut than was widely expected. When it meets in November, the MPC will doubtless take into account the collapse of the Government coalition and the imminent Parliamentary elections, but these political uncertainties are unlikely to prevent them from putting another rate cut through if other factors argue in favour of it. We expect the monetary easing phase that started in October to continue largely unabated in coming quarters.


All members of the MPC voted in favour of Governor Ásgeir Jónsson’s proposal to lower the CBI’s key interest rate by 25 basis points on 2 October, although Herdís Steingrímsdóttir would have preferred to hold rates unchanged. It appears that there was a broader consensus among Committee members than might have been expected, given the lively exchange of opinion among CBI officials at the press conference following the announcement of the decision. Both the voting pattern and the discussions within the Committee indicate a stronger change of tack since the August rate-setting meeting than we – and surely many others – anticipated. The shift can be seen in the minutes from the MPC meeting held on 30 September and 1 October 2024, published yesterday on the CBI website.

It is worthwhile to recall that according to the minutes from the MPC’s August meeting, the possibility of a rate cut was not even mentioned at that time At the October meeting, however, members discussed two options: lowering the key rate or holding it unchanged at 9.25%.

According to the minutes from that meeting, members considered the strongest arguments in favour of a rate cut to be the following:

  • Members agreed that various indicators suggested that growth in economic activity had continued to taper off.
  • Inflation had fallen more than anticipated, the contribution of domestic goods and services to inflation had eased, and price increases were less widespread than before.
  • Inflation expectations had fallen by some measures.
  • Although labour demand was still strong, there were clear signs of a slowdown, as job growth had lost pace and registered unemployment had continued to inch upwards.
  • Staff shortages had apparently subsided, firms had scaled down their staff recruitment plans, and the share of companies operating at full capacity had fallen.
  • The recent increase in the commercial banks’ indexed mortgage rates and structural changes in the credit market that had caused borrowing terms to tighten could lead to a more rapid downturn in lending growth than would otherwise be seen.
  • This could result in a more rapid decline in housing market activity, whereas the rise in the housing component of the CPI still accounted for a large share of headline inflation.
  • Overall economic activity could lose pace quickly in 2025.
  • Many factors had therefore moved in the right direction in the recent term, and the impact of high real interest rates was clearly visible.

The main arguments in favour of leaving the key rate unchanged were as follows:

  • About half of the recent drop in inflation was due to one-off items, and underlying inflationary
  • It was not clear that underlying inflationary pressures had tapered off decisively between meetings.
  • Domestic demand remained strong, the real estate market was still robust, and payment card turnover figures suggested that demand had picked up in Q3, as previous wage increases were still supporting demand.
  • It therefore appeared that underlying demand pressures remained in the economy.
  • Households’ position was strong overall, as could be seen in a high saving rate and strong growth in deposits.
  • Under these circumstances, Government transfers to households could stimulate demand.
  • Even if inflation continued to fall in the near term, it could then plateau at a level somewhat above target; therefore, it was important to maintain a tight monetary stance further ahead.
  • Although the newly introduced fiscal budget proposal provided for a more or less neutral fiscal stance in 2025, it had yet to be discussed in Parliament.

The MPC then summarised these factors in the following assessment (our boldface):

On the whole, growth in economic activity had eased steadily since 2023. The Committee agreed that the monetary stance had tightened in the recent term, particularly in view of the fact that transmission to long-term real rates had grown more effective. In addition, it was likely that the stance would tighten further in the coming term. In light of this, it would be possible to lower nominal interest rates cautiously, while still maintaining an appropriate monetary stance.

Will the collapse of the coalition Government and the upcoming elections affect the November policy rate decision?

As we see it, it is inevitable that the MPC will discuss the collapse of the Government and the looming Parliamentary elections at its November meeting, as the elections are slated for the end of that month. It is therefore useful to examine how such a turn of events has been reflected in MPC discussions and decisions in recent years, particularly when the situation boils over at relatively short notice, as is the case now.

Many remember the political tremors in 2016-2017, when Parliamentary elections were held in the autumn of both years. In autumn 2016, the MPC made reference to uncertainty about elections and the change in Governments in November, when it held the policy rate unchanged, and again in December, when it lowered rates by 0.25 percentage points. For instance, the Committee’s November 2016 statement reads as follows:

The MPC’s decision to keep interest rates unchanged is taken upon consideration of the Bank’s current forecast and the Committee’s own 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.

The MPC minutes from that November meeting include the following:

“ … even though conditions for a rate cut could be developing, it was not timely to take such a decision because uncertainty about important factors had increased, at least in the short run. Most important among them were the uncertainties about the fiscal stance following the recent elections and the incoming government’s economic policy.”

In December 2016, however, the MPC lowered the policy rate by 0.25 percentage points, even though “there was still considerable uncertainty about near-term wage developments and about the fiscal stance.”

A new Government took office in mid-January 2017.

In October 2017, a month after that Government’s sudden collapse, the MPC discussed the recent turbulence at its rate-setting meeting:

The Committee also discussed the impact on monetary policy of the collapse of the Government and the forthcoming elections. In Committee’s view, increased uncertainty – political and otherwise – could contain demand if it caused households and businesses to exercise caution. Increased uncertainty could also lead to cross-border capital outflows, which could cause the exchange rate to fall and could call for changes in interest rates. In the MPC’s opinion, however, there were no clear signs of capital outflows due to these factors as yet. On the other hand, members were of the view that there was some risk that as a result of the election campaign, the cyclically adjusted Treasury balance to deteriorate, which would call for higher interest rates than would otherwise be needed. It was mentioned as well that increased credibility of monetary policy made it easier for the Committee to look through the temporary impact of increased political unrest now than, for example, when the Government fell at the same time in 2016, as there was now less risk that such temporary unrest would affect long-term inflation expectations.

The MPC lowered the policy rate by 0.25 percentage points at that October 2017 meeting. It kept rates unchanged that November, however, citing, among other things, “the easing of the fiscal stance in 2017 and the two preceding years, although the fiscal budget proposal for 2018 indicated that this should reverse in part in the years to come. [Committee members] considered the fate of the budget proposal highly uncertain, however, and were of the view that further fiscal easing in coming years would require a correspondingly tighter monetary stance.”

Both the statements above and the priorities most political parties appear to be espousing during the run-up to this year’s elections suggest to us that uncertainty about the elections themselves and the ensuing Cabinet formation period could deter the MPC from lowering interest rates substantially in November. On the other hand, we think it unlikely that such concerns will carry the day if the Committee is convinced that other factors – such as inflation, inflation expectations, and the economic outlook – provide grounds for a rate cut.

Further policy rate cut likely before the year-end

Developments unfolding in the wake of the MPC’s early October meeting have tended to strengthen the rationale for a rate cut in November. For instance, both short- and long-term breakeven inflation rates in the bond market have fallen somewhat. Furthermore, the Housing and Construction Authority’s (HMS) newly published house price index and rent price index indicate that pressures in the markets have eased, as both indices declined in September.

Presumably, the October inflation measurement will be an important driver of the November interest rate decision. We forecast a continuing decline in headline inflation, from 5.4% to 5.2% this month.

As a result, we think it more likely than not that the policy rate will be lowered again in November. How large a step the MPC takes at that time will depend not least on developments in the factors discussed above and in coincident indicators published over the next few weeks. Thereafter, monetary easing will continue more or less uninterrupted through mid-2026, provided that the assumptions underlying our recent inflation and macroeconomic forecast are borne out.

Analyst


Jón Bjarki Bentsson

Chief economist


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