According to today’s MPC statement, the GDP growth outlook for 2021 is broadly unchanged, while prospects for 2022 have improved markedly, although pronounced uncertainty remains, particularly as regards developments in the pandemic. Furthermore, the contribution from domestic cost pressures, rising house prices, and wage growth has accounted for a large share of inflation recently, although the effects of imported price hikes have grown stronger as well. Underlying inflation is lower, however, and has declined recently.

The inflation outlook has deteriorated relative to the August forecast, due to the aforementioned factors and the more rapid economic recovery. The outlook is for inflation to continue rising in coming months but then start to ease, given that inflation expectations remain anchored to the target.

The forward guidance in today’s statement takes a somewhat tougher stance than before:

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.

The difference between this statement and its predecessors is the addition of the word reiterates, indicating stronger emphasis on this stated goal of the MPC. And at this morning’s press conference, CBI officials said that this change in wording was no coincidence but instead a reflection of the Committee’s determination to wield the interest rate tool as it has done today.

Sunnier outlook for GDP growth in 2022

The CBI published a new macroeconomic forecast alongside today’s interest rate decision. The GDP growth outlook for 2021 is broadly unchanged from the previous forecast, at 3.9%, with the improved outlook for H2 offsetting a weaker-than-expected H1. But the forecast for 2022 was revised upwards from 3.9% to 5.1%, owing to a brighter outlook for exports. The CBI is of the view that tourism will recover more swiftly, and that goods exports will be stronger because of the increased capelin quota, which is expected to boost next year’s output growth by 0.7%. But there is still a high level of uncertainty about the pandemic, and economic developments will be affected by the path it takes. The CBI’s GDP growth forecast is quite similar to our own most recent scenario, published in the wake of reports on next year’s expected capelin boom. The only difference is that we forecast slightly weaker growth in 2022 and a correspondingly stronger 2023.

Furthermore, the CBI projects lower registered unemployment in 2021 than in its previous forecast, or 7.7% instead of 8.1%. In October, registered unemployment measured 4.9%, and if it remains there through the year-end, the measurement for 2021 as a whole will indeed be 7.7%, as the CBI envisions. For 2022, the bank forecasts registered unemployment at 5.2%, which is interesting in view of where the jobless rate is now. In spite of this, the CBI is convinced that the slack in the economy is about to close or has perhaps already done so, and that unemployment will continue to fall to around 4%, close to its estimated equilibrium level, by the end of the forecast horizon.

The inflation outlook has deteriorated

The CBI has revised its inflation forecast upwards since August, and it considers the inflation outlook to have eroded. Inflation looks set to remain above 4% for longer than previously anticipated, and not to fall below 3% until Q4/2022. The bleaker inflation outlook stems from higher imported inflation and a poorer initial position than was assumed in the August forecast. The CBI projects Q4/2021 inflation at 4.7%, giving a figure of 4.4% for the year as a whole. It also forecasts that inflation will average 3.5% in 2022 and 2.9% in both 2023 and 2024. What is interesting about this scenario is that the CBI appears not to expect inflation to return to target by the end of the forecast horizon, whereas it usually ends up aligning with the target in the bank’s long-term forecasts.

We consider the CBI’s 2022 inflation forecast overly optimistic. We project that inflation will be somewhat higher, particularly in 2022, when we expect it to average 4.2%. But we agree with the bank’s projection that inflation will approach the target over the course of 2023.

CBI officials’ responses to our questions reveal that they are quite concerned about near-term wage developments and the associated impact on inflationary pressures. As they put it, the economy is set to take on wage hikes that are not supported by productivity growth. This applies, among other things, to the GDP growth supplement that will presumably be triggered in Q2/2022. The GDP growth supplement was intended to give workers a share in rising output, but obviously, the negotiating parties could not have foreseen the developments of the past several quarters, which feature a deep contraction together with GDP growth that represents a recovery rather than additional growth.

CBI officials also mentioned the bank’s role in preserving the value of money in Iceland, including real wages. One can only hope that the social partners will trust them on this score. If external conditions deteriorate, it would surface in domestic wages. As regards dialogue, the CBI is an independent entity. To paraphrase Governor Ásgeir Jónssson’s observations, giving in to all of the outcry urging wage rises in response to CBI rate hikes would be the very antithesis of sensible policy.

CBI officials also discussed developments in the real estate market, pointing out that they showed in part how well incomes and living standards have been maintained throughout the Corona Crisis. Increased importation of labour and other demand-side factors reflected the economic recovery but also put pressure on house prices. The CBI assumes that interest rates will bite faster, and they expect the bank’s macroprudential tools to affect house prices and demand as well, although it is not yet clear how much. The important thing is that all of these factors are working together.

Rate hike process to continue

In our opinion, the monetary tightening phase reflects both the economic recovery and the worsening inflation outlook. Most likely, the tightening phase is nowhere near its end, and as before, we expect the CBI to raise interest rates at each of its rate-setting meetings in H1/2022 and then ease the pace until rates hit 3.5% around mid-2023.