MPC statement strikes a sterner tone

According to this morning’s MPC statement, even though the housing market has begun to cool and global inflation has eased slightly, inflationary pressures are still pronounced and price increases widespread. The inflation outlook has worsened since the MPC’s last meeting, and although inflation has most likely peaked, bringing it back to target will take longer than previously anticipated.

In the MPC’s opinion, the deterioration in the inflation outlook stems in particular from the recently finalised private sector wage agreements, which entail considerably larger pay rises than previously assumed. Furthermore, the króna has depreciated, and the outlook is for a larger positive output gap during the forecast horizon. Then there is the prospect of a more accommodative fiscal stance than was provided for in the Bank’s November forecast, even though the fiscal deficit will narrow this year. Long-term inflation expectations are still well above target, and the Bank’s real rate has declined since the MPC’s last meeting.

The forward guidance in today’s statement is vastly different from that in the November statement. This morning’s epistle is short and succinct, conveying a distinctly admonitory message.

It reads as follows:

The MPC considers it likely that the monetary stance will have to be tightened even further in the coming term so as to ensure that inflation eases back to target within an acceptable time frame.

We have not seen such vacuum-packed forward guidance in quite a long time. In a departure from other recent statements from the MPC, there is no mention of potential determinants of the near-term monetary stance. As a result, we think it likely that the MPC will raise the policy rate further in coming months.

GDP growth to ease marginally during the forecast horizon

The CBI has issued a new macroeconomic forecast in Monetary Bulletin, published alongside today’s interest rate decision. Because private consumption grew more than expected and external trade was more favourable, the CBI estimates year-2022 GDP growth at 7.1%, somewhat above its last forecast but broadly in line with Íslandsbanki Research’s projections. On the other hand, the CBI has revised its output growth forecast for 2023 and 2024 slightly downwards, in view of the worsening outlook for growth in private consumption and external trade. According to the CBI forecast, GDP growth will measure 2.6% in 2023, 2.5% in 2024, and 2.1% in 2025.

The CBI’s forecast is somewhat more downbeat than our own new macroeconomic forecast, as we have projected GDP growth at 3.4% for both 2023 and 2024. The main difference is that we forecast slightly more investment during the period, as well as stronger export growth.

The CBI is also more pessimistic than we are about prospects for the labour market. According to the new Monetary Bulletin, the CBI assumes that, relative to its November forecast, total hours worked will rise more slowly over the forecast horizon and unemployment will therefore rise faster. Unemployment according to Statistics Iceland’s (SI) labour force survey (LFS) is forecast to measure 4% in 2023 and rise to 4.6% by the end of the forecast horizon, and registered unemployment is expected to develop similarly.

At Íslandsbanki Research, we prepare forecasts for registered unemployment only, but our projections are lower than the CBI’s are. We forecast that unemployment will average 3.3% in 2023 and then increase marginally in 2024, in response to reduced tension in the labour market. It should be noted, though, that unemployment is measured in two ways – through the LFS, on the one hand, and through registered unemployment, on the other – although the two generally move in line with one another.

The inflation outlook has deteriorated

Inflation looks set to be higher and more persistent in 2023 and 2024, according to the CBI forecast. The bank projects average inflation at 7.2% this year and 4.2% in 2024, which is far more pessimistic than its November forecast. The bleaker inflation outlook reflects the unexpectedly large increase in wage costs and the relative weakness of the ISK, offset by the cooler housing market and the surprisingly rapid decline in global inflation.

 The CBI’s most recent inflation forecast is broadly in line with our own, in that it provides for a relatively swift drop in inflation in the near future. We are a bit more pessimistic about the next two years, however, as we forecast average inflation at 7.6% and 4.5%, respectively, in 2023 and 2024.

Is the CBI alone standing guard on inflation?

At this morning’s press conference on the interest rate decision, Governor Ásgeir Jónsson mentioned that most aspects of the inflation outlook had pushed against the CBI since the MPC’s November meeting. The newly landed wage agreements, for instance, were far more front-loaded and had provided for much larger pay rises than the CBI had projected. Short-term contracts had now taken effect for a large share of the private sector, and the Governor viewed this as a window of opportunity to bring inflation down over the remainder of this year.

These remarks took us by surprise, actually, as the comments made by CBI officials just after the wage agreements were reached had been relatively sanguine. Furthermore, we do not expect the wage agreements to change the inflation outlook for this year to the degree estimated by the CBI. To be sure, the pay rises provided for are considerably larger than would be consistent with price stability because, as we see it, rising wage costs will contribute proportionally more to inflation in the coming term than they have in the recent past.

In addition, the fiscal stance is more accommodative than had been anticipated, providing the CBI’s monetary policy with less support from other economic policy agents. Moreover, national saving has diminished in both private and public sectors, and it is important to ensure that it increases again.

Further policy rate hikes ahead

As is noted above, this morning’s terse forward guidance from the MPC focuses entirely on the need for a tighter monetary stance. That being the case, it is difficult to avoid concluding that further rate hikes are in the cards in coming months – unless inflation falls steeply and/or the inflation outlook improves to a marked degree.

Our preliminary forecast assumes that the policy rate will rise by at least another 0.5 percentage points. That increase will come either in one fell swoop at the MPC’s next meeting (in late March) or in two 0.25-point increments, one in March and the other in mid-May. The CBI’s key interest rate could therefore peak at 7.0% this spring. If inflation and inflation expectations develop less favourably than we expect, the key rate could end up even higher. And the question of whether the CBI embarks on a monetary easing phase before the year-end or waits until 2024 will depend on whether the bank can take advantage of the window of opportunity the Governor mentioned and bring inflation back onto a more promising path.