The CBI announced this morning that the Monetary Policy Committee (MPC) had decided to raise the policy rate by 0.25 percentage points. The Bank’s key interest rate – the rate on seven-day term deposits – is now 6.0%, its highest since Q3/2010. Today’s rate hike was at the upper end of the range of official forecasts. We had projected a 25-bp rate hike, but others had forecast that rates would remain flat.
Central Bank closes out a year of monetary tightening with a 25-bp rate hike
The Central Bank of Iceland (CBI) raised its policy interest rate by 0.25 percentage points today, its last announcement date of the year, citing unfavourable developments in inflation, resilient demand growth, and persistently high inflation expectations as grounds for the decision. As before, the CBI considers the economic outlook reasonably good and expects inflation to taper off steadily in the coming term. It is quite likely that this rate hike puts an end to the bank’s monetary tightening phase, but the margin for error is narrow, and it would take little to prompt a further rate increase in the new year.
The policy rate has now been raised by 5.25 percentage points since May 2021, when the tightening phase began.
The highlights from the MPC statement are as follows:
- Inflation picked up again slightly in October, to 9.4%.
- Price increases are widespread, and underlying inflation has continued to rise.
- The ISK has depreciated since the MPC’s October meeting.
- The long-term breakeven inflation rate in the bond market has risen somewhat.
- Indicators imply that inflation expectations have become less firmly anchored to the target, and it could therefore take longer than it would otherwise to bring inflation back to target.
The MPC’s forward guidance is repeated verbatim from its October statement, and the tone is relatively neutral.
It reads as follows:
The MPC will continue to ensure that the monetary stance is tight enough to bring inflation back to target within an acceptable time frame. Near-term monetary policy decisions will depend on developments in economic activity, inflation, and inflation expectations. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of developments in interest rates in the coming term.
We interpret this to mean that the Committee is keeping all options on the table for its first interest rate decision of 2023. Based on our perspective on the near-term economic and inflation outlook, however, it is quite likely that today’s rate hike marks the end of the current monetary tightening episode.
GDP growth shifts between years
The CBI has issued a new macroeconomic forecast in Monetary Bulletin, published alongside today’s interest rate decision. The bank has lowered its year-2022 GDP growth forecast from 5.9% (the August forecast) to 5.6%, owing to weaker growth in the H1/2022, whereas the outlook for H2 is unchanged. The bank considers the outlook for 2023 to have improved, however, and it now projects growth at 2.8%, up from the August forecast of 1.9%. The upward revision is due primarily to the prospect of more rapid growth in domestic demand, as disposable income has been rising considerably faster than previously assumed. For 2024, the CBI projects GDP growth at 2.6%, which is marginally above its August forecast.
The bank’s output growth forecast for 2022 is somewhat more pessimistic than our macroeconomic forecast from September. We expect GDP growth to measure just over 7% this year. The CBI projects a faster growth rate in 2023, however. The main difference between the two forecasts is that we expect more rapid growth in private consumption and investment in 2022, while the CBI expects this uptick to take place in 2023.
According to Monetary Bulletin, indicators imply that tensions in the labour market are easing. The CBI’s forecast for registered unemployment in 2022 is unchanged since August, at 3.8%. Unemployment will measure 3.5% in 2023, according to the bank’s projections, and then inch upwards towards the end of the forecast horizon, measuring 3.7% in 2024.
Inflation outlook considerably brighter
The CBI considers the inflation outlook to have changed significantly relative to its August forecast, which proved notably pessimistic. The bank now expects inflation to hold steady for the remainder of 2022, averaging 9.4% in Q4. If this is borne out, inflation will average 8.3% for the year as a whole. The bank’s forecast then assumes that inflation will fall rather swiftly in 2023 and average 6% for that year. For 2024, the CBI expects inflation to average 3.6% for the year as a whole and to measure 3.4% in Q4. Inflation is therefore moving in the right direction, although the target is still far off.
As is noted in Monetary Bulletin, price increases are widespread and underlying inflation is still rising. Given the recent slowdown in housing market activity, the composition of inflation is likely to change in the near future. The contribution of the housing component to headline inflation will continue to decline, while the contribution from goods price hikes will rise.
Hoping for the best, but preparing for further rate hikes
At the CBI’s press conference this morning, bank officials stressed that they hoped this rate hike would prove sufficient. They were prepared, however, to respond with further rate increases if domestic demand and inflation should develop unfavourably in coming months, or if other agents that could affect the inflation outlook – i.e., the social partners and the Government – do not join with the bank in its bid to bring inflation down.
In response to a question, Governor Ásgeir Jónsson said that underlying demand for housing was apparently still strong, not least because of the influx of imported labour and the resurgence of the tourism industry.
Furthermore, it was clear that private consumption was still buoyant, perhaps because the savings accumulated during the pandemic were more substantial than previously assumed, not to mention that disposable income had risen markedly – at least until last month. High imported private consumption – which could be seen, for instance, in frequent overseas travel – had affected the ISK exchange rate in recent months. Although the CBI adhered to its policy of mitigating short-term exchange rate volatility, it did not intend, as the Governor put it, to “use the foreign exchange reserves to finance the general public’s junkets to the Canary Islands.” The CBI’s Chief Economist said when asked that the bank expected year-on-year private consumption growth to slow markedly in the quarters to come, particularly because of base effects from the past few quarters’ consumption spree. Even so, private consumption remained resilient, and the CBI expects it to keep growing year by year over the forecast horizon.
Is the rate hike process complete?
The CBI’s next interest rate decision date is quite a way off – probably in early February, if this year’s calendar is anything to go by. By then, perhaps there will be greater clarity about private sector wage negotiations, a slightly lower rate of inflation, and more unambiguous signs of reduced demand pressures in the economy and labour market.
We think that if this turns out to be the case, the current spate of interest rate hikes will indeed prove to have been sufficient and the policy rate will remain unchanged at 6% until mid-2023, whereupon it will start to fall again in the latter half of the year. But there is very wiggle room as regards inflation, inflation expectations, and demand growth, and if developments are unfavourable, the CBI may consider itself forced to raise the policy rate a bit higher.