According to this morning’s MPC statement, GDP growth is strong and the slack in the economy that opened up in the wake of the pandemic has probably closed, although pronounced uncertainty remains. Furthermore, the inflation outlook has worsened, and inflation expectations have risen by some measures in the recent term. The Committee’s forward guidance is unchanged since the last meeting:

The MPC reiterates that it will apply the tools at its disposal to ensure that inflation eases back to the target within an acceptable time frame.

Thus the tone taken by the Committee is stern, in keeping with the recent pattern.

New forecast presents a fairly bright economic outlook

The CBI has issued a new macroeconomic forecast in its newest Monetary Bulletin, published alongside today’s interest rate decision. The bank is of the opinion that GDP growth will be marginally weaker in 2022 than was forecast in November, mainly because of the adverse impact of the Q1 spike in COVID case numbers. In November, the CBI had projected that 1.5 million tourists would visit Iceland this year, but in view of the poorer outlook for Q1, it has revised this estimate downwards. As a result, the bank has lowered its year-2022 GDP growth forecast from 5.1% to 4.8%, which is quite close to our own recent forecast of 4.7%. The CBI has revised its forecast for 2023 downwards as well, from 2.6% to 2.1%, whereas we have projected next year’s GDP growth at 3.2%.

The CBI also projects that unemployment will average 4.9% in 2022, as opposed to 5.1% in the November forecast. According to the new Monetary Bulletin, many firms are planning to add on staff, but it appears that jobs are being filled to a greater degree with imported labour and increased labour participation. We share this opinion, although we expect unemployment to fall faster than the CBI does. In our macroeconomic forecast, we project average unemployment for this year at 4.5%. Registered unemployment measured 4.9% in December, and it looks set to fall somewhat this year once tourism, the country’s largest export sector, regains its momentum.

According to the recent Gallup survey carried out for the CBI and the Confederation of Icelandic Employers (SA), nearly 40% of company executives consider themselves short-staffed. We are therefore of the view that unemployment will decline faster than the CBI forecast assumes. According to our forecast, it will fall to its pre-pandemic level later this year.

Bleak inflation forecast; inflation risk tilted to the upside

The CBI has revised its near-term inflation forecast sharply upwards since November, citing the stronger domestic economic recovery, higher house price inflation, and more persistent foreign inflation than previously assumed. The bank therefore projects that inflation will measure 5.8% in Q1 and 5.6% in Q2, and not fall below 4% until the beginning of 2023. It is noteworthy that inflation will not return to target during the forecast horizon but will measure 2.7% at the end of the period, which extends until the beginning of 2025. At this morning’s press conference following the announcement of the decision, it emerged that uncertainty about inflation was significant, and concentrated on the upside. It also emerged that even though the impact of house price inflation and rising prices of foreign goods and inputs would diminish, rising wage costs would be a strong driver of inflation over the entire forecast horizon and would play a leading role in how slowly inflation fell to target later in the period.

Increased monetary restraint following successful pandemic response

In response to questions posed at the press conference, CBI officials said that despite the rate hikes in recent quarters, the real policy rate was low and monetary policy therefore still accommodative. The MPC did not want to tighten the monetary stance too quickly, as there were other policy instruments whose impact had yet to come to the fore. This refers to macroprudential tools such as the reduced maximum loan-to-value ratio and the capped debt service ratio on new mortgage loans. Furthermore, the Committee wanted to foster increased growth in business investment.

CBI officials pointed out as well that monetary policy had been strengthened in the past wo years; for instance, Iceland had built up a new mortgage lending system that was far more responsive than before to changes in interest rates. More assertive housing market measures taken by the Financial Stability Committee (FSN) had supplemented more effective monetary policy transmission, in the CBI’s opinion.

When asked about the effects of the rate hike on leveraged households, CBI officials said that monetary policy could not focus on specific groups. Households were responding on their own – for instance, by choosing fixed-rate rather than floating-rate mortgages. Changes in the mortgage lending market had given households greater latitude in choosing from among various loan types and in responding to changes in interest rates, although naturally, not all borrowers were able to do so.

It was also pointed out that when the export sector more or less evaporated overnight, one of the aims of cutting the policy rate was to incentivise private consumption. The rate cuts had been passed through to households, and measures had been taken to support the ISK so as to maintain purchasing power. As a result, consumers’ purchasing power had increased during the pandemic. Now, however, the time had come to withdraw this incentive. On the other hand, stimulative Government measures, if implemented, would offset the tighter monetary stance. CBI officials called for greater consensus on dampening demand and reducing demand-generated inflationary pressures.

And finally, the bank’s officials rejected the notion that it had been a mistake to slash interest rates at the beginning of the pandemic, pointing out that efforts to minimise the repercussions of the pandemic for households and businesses had been successful and that the position of households, businesses, the financial system, and the public sector was generally strong despite the knockout punch delivered to the country’s largest export sector, as well as the wide-ranging disruption of other economic activity. It appeared that the effects of the pandemic would prove much more temporary than originally feared and that long-term scarring would be limited.

We agree with this assessment by the CBI, as can be seen in our macroeconomic forecast, which states that the economic policy response by Governmental authorities, including the CBI, had played a major role in cushioning against the pandemic-induced blow to the Icelandic economy.

Further policy rate hikes on the horizon

As before, we expect the CBI to continue on its monetary tightening path in the coming term, as the economy recovers and the effects of the pandemic taper off. Lower inflation further ahead should mitigate the need for rapid nominal interest rate hikes.

We expect rate hikes of at least 0.25 percentage points in each quarter for the rest of 2022, which would bring the policy rate to 3.5% by the year-end. If inflation proves even more stubborn than we expect, interest rates could be raised more quickly. Thereafter, we expect interest rates to rise gradually and, as before, we estimate that the monetary tightening phase will end at 4.0%, assuming that the CBI ultimately wins the bout with inflation and that inflation falls to an acceptable level further ahead.