Central Bank: Navigating through the rear-view mirror?

The Central Bank (CBI) Monetary Policy Committee’s (MPC) decision to keep the policy rate unchanged, coupled with the neutral forward guidance in this morning’s statement, indicate that the MPC is looking in the rear-view mirror rather than looking ahead in its consideration of economic prospects and other factors. It has become more likely that the CBI’s monetary easing phase could begin later than expected. By the same token, we think there is an increased risk that monetary policy will prove more procyclical than countercyclical in the near future.

The CBI announced this morning that the MPC had decided to hold the policy rate unchanged. The key interest rate – defined as the seven-day collateralised lending rate – will therefore remain steady at 9.25%, where it has been since late August 2023. During the run-up to the decision, opinion was divided on whether the MPC would hold the policy rate steady or lower it, as could be seen in official forecasts and media polls alike. We projected that the Committee would cut the policy rate by 0.25 percentage points this time, and we argued that such a rate reduction would be sensible.

But more surprising than the interest rate decision itself is the tone taken in the MPC statement and at this morning’s press conference about the decision. The MPC statement provides no indication that monetary easing is likelier than monetary tightening in the quarters to come. The highlights of the MPC statement are as follows:

  • Inflation eased slightly in February, to 6.6%.
  • Underlying inflation has also eased but, like headline inflation, is well above the inflation target.
  • Inflation expectations are also above target, which could indicate that inflation will remain persistent.
  • The upward revision of GDP growth figures in Statistics Iceland’s (SI) data indicate that the output gap is wider than previously estimated.
  • Economic activity continues to ease, however, as the monetary stance is tight.
  • Uncertainty has receded with the signing of private sector wage agreements.
  • However, demand pressures in the economy could lead to more wage drift than would otherwise occur.
  • Furthermore, discretionary fiscal measures could increase demand and inflationary pressures.

The MPC’s forward guidance is the same as in February, and reads as follows:

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

Perseverating on the strong GDP growth of recent years

At this morning’s press conference on the interest rate decision, CBI Governor Ásgeir Jónsson made repeated reference to SI’s recent revision of the past few years’ national accounts data, where GDP growth in 2020-2023 is now estimated to have been stronger than in previous figures and the first three quarters of 2023 have also been revised upwards. The Governor reiterated more than once that 20% GDP growth over a three-year period was highly unusual. In this context, though, it should be borne in mind that a sizeable share of that growth is due simply to the recovery from a steep drop at the beginning of the pandemic and, as such, does not reflect growth in economic activity relative to the pre-pandemic period.

In addition, Rannveig Sigurðardóttir, Deputy Governor for Monetary Policy, considered SI’s revisions a sign that the output gap was larger than previously estimated. This interpretation is questionable on a number of counts, however.

  • First of all, the Icelandic economy is highly flexible in terms of capacity utilisation, particularly as regards the labour force. Icelandic nationals move to and from Iceland depending on the employment situation, and the same applies to an even greater extent to migration of foreign nationals to and from the country.
  • In our opinion, the fact that SI’s revision centres primarily on investment rather than, say, private consumption diminishes the need for a major revision of the output gap.
  • Developments in 2023 show a stark reversal from nearly 9% GDP growth in Q1 to 0.6% growth in Q4.

Furthermore, CBI officials seemed relatively unconcerned that the worsening outlook for exports in 2024 would lead to a more rapid cooling of the economy than the CBI forecast in February. Moreover, it was pointed out at the press conference that recent surveys suggested greater optimism about the economic outlook than previous surveys had. On this point, it can certainly be argued that the recently landed wage agreements, plus expectations that inflation and interest rates will fall relatively quickly, are likely factors, and it would be interesting to see the data referenced by CBI officials in this context. Surprisingly, the discussion at today’s press conference, like the MPC statement published this morning, made very little reference to what lies ahead for the economy, focusing instead on statistics of various vintages. In light of this, it can be inferred that to an excessive degree, the MPC is conducting monetary policy more by looking in the rear-view mirror than by looking straight ahead at the highway.

Muted response to newly landed wage agreements

It took us somewhat by surprise how little effect the recent wage agreements appear to have had on the MPC’s decision. Although contracts with large worker groups are still outstanding and the risk of wage drift is considerable, the newly signed agreements themselves are in many ways the most favourable Iceland has seen in quite some time, in terms of the inflation outlook. In our opinion, greater attention should have been paid to this milestone.

As before, the MPC strongly emphasises inflation expectations, which undeniably are too high by most if not all measures. But it can be argued that measures such as the long-term breakeven inflation rate in the bond market are not far from the target, once account has been taken of the fact that the uncertainty premium on long-term nominal bonds is probably on the high side at present.

Will monetary easing be delayed?

As we have noted above, the MPC’s forward guidance is very terse and the tone noncommittal. The statement does not signal that the bank is gearing up for a monetary easing phase starting in the next few months. Nevertheless, we think it more likely than not that the MPC will start easing monetary policy with a rate cut in May, although the probability of a further delay has increased with today’s news. By the same token, we think there is a greater risk than before that the CBI’s response to the changed outlook will come later than it should, and that monetary policy will prove procyclical rather than countercyclical in the coming term. We sincerely hope this will not be the case.


Jón Bjarki Bentsson

Chief economist