The CBI announced on Wednesday that the MPC had decided to raise the CBI’s policy rate by 1.25 percentage points. The CBI’s key interest rate – the rate on seven-day term deposits – will therefore be 8.75% and will have risen by 8 percentage points in the past two years. It is now at its highest since early 2010. The increase was larger than had generally been forecast. Analysts from all of the commercial banks, ourselves included, projected a rate hike of 1 percentage point. The MPC also decided to increase deposit institutions’ fixed minimum reserve requirement from 1% to 2%.
Central Bank stomps on the brakes
A hefty policy rate hike, an increase in minimum reserve requirements, and a no-nonsense prognostication of further monetary tightening show the Central Bank (CBI) Monetary Policy Committee (MPC)’s determination to drop a net over inflation and inflation expectations as soon as possible. The CBI’s new macroeconomic forecast, which sketches a picture of a hotter economy and more stubborn inflation than the previous one did, can be viewed as a cautionary tale that Bank officials are taking to heart. The policy rate is likely to rise further in the second half of the year.
According to Wednesday's MPC statement, economic activity has been strong year-to-date, and GDP growth looks set to be far above the bank’s previous forecast. Underlying inflation is still increasing, and steep price hikes can be seen in a steadily growing share of the consumption basket. The outlook is for considerably stronger inflationary pressures in 2023 and 2024 than was previously assumed. Furthermore, long-term inflation expectations have risen and are well above the target, and there is a greater risk that inflation will become entrenched.
CBI forecasts stronger GDP growth and a hotter economy in the near term
The CBI has issued a new macroeconomic forecast in Monetary Bulletin, published alongside the interest rate decision. The bank estimates that GDP growth far outpaced the February forecast in Q1/2023 and looks set to exceed it for the year as a whole as well. It forecasts year-2023 GDP growth at 4.8%, nearly double the 2.6% it projected in February. The upward revision of the GDP growth forecast is due to even stronger growth in domestic demand and a more favourable outlook for tourism. GDP growth prospects for 2024 and 2025 are broadly in line with the CBI’s February forecast, however.
The CBI’s forecast for 2023 is considerably more optimistic than those from other forecasters, as can be seen in the chart above. We project this year’s output growth at 3.4%, although that forecast dates from early February.
The CBI has revised its year-2023 unemployment forecast slightly downwards. The labour market remains tight, and strong labour demand is being addressed with a historically large expansion of the foreign work force. The CBI expects unemployment to measure 3.7% in 2023 and then rise in 2024 and 2025, as tensions in the labour market ease.
Inflation to remain intractable
Underlying inflation has continued to climb, and most measures have increased markedly since the beginning of the year. Inflation is therefore widespread, giving cause for real concern. The outlook is for inflation to exceed the CBI’s previous forecast in both 2023 and 2024. Demand pressures in the economy look set to be stronger, albeit offset by a stronger ISK and a decline in global inflation. The CBI projects that inflation will average 8.8% in 2023, 5% in 2024, and 3.4% in 2025. According to the bank’s forecast, inflation will not realign with the target until mid-2026.
The CBI’s new inflation forecast is in line with our own most recent one. For 2023 as a whole, we expect inflation to average 8.7%. As the chart indicates, our forecast from early February was far more optimistic, as we had projected average inflation for the year at 7.6%.
Bringing inflation to heel before the winter is of vital importance
At the press conference following today’s interest rate decision, we asked whether the CBI’s new macroeconomic forecast could be viewed as a scenario that the MPC was responding to pre-emptively by tightening the monetary stance now. Governor Ásgeir Jónsson agreed with that interpretation, saying that the CBI needed to respond so as to prevent the forecast of continued heating and stubborn inflation from materialising.
Rannveig Sigurðardóttir, Deputy Governor for Monetary Policy, concurred, saying it was important to make progress in the fight against inflation before the next round of wage negotiations begins in earnest in Q4.
Both Ásgeir and Rannveig reiterated their concerns that support from other economic policymakers was insufficient. They mentioned, among other things, an article in the new issue of Monetary Bulletin, in which the impact of tighter fiscal policy was estimated at a combined ISK 100bn over the next two years, and concluded that a far lower policy rate would be needed to bring inflation into line if this fiscal consolidation were put into action. They also expressed their disappointment at many labour market representatives’ assertions that there was no particular cause-and-effect relationship between steep nominal pay rises and higher interest rates. The said that if the social partners refused to shoulder their responsibility, the CBI would have to wield the policy rate more aggressively than would otherwise be needed.
Further policy rate hike likely in H2
The forward guidance in Wednesday's MPC statement is radically different from that in the last statement, and the tone of the message is uncompromising.
It reads as follows (our boldface):
“ … it is necessary to tighten the monetary stance still further. It is especially important to prevent a wage-price spiral, particularly in view of the strong demand pressures in the economy and how soon the next round of wage negotiations will begin. Therefore, the outlook is for further rate hikes in order to ensure a better balanced economy and bring inflation back to target.”
Clearly, this three-pronged approach by the MPC – a hefty rate hike, increased reserve requirements, and unequivocal forward guidance – is evidence of the Committee’s commitment to bringing inflation and inflation expectations under control as soon as possible. In his remarks this morning, the Governor said that increasing minimum reserve requirements further in coming quarters, as an element in tightening the policy stance, was a distinct possibility.
The interval between the CBI’s interest rate decisions is unusually long this time, with the next regularly scheduled meeting slated for 23 August. Presumably, this plays a role in the MPC’s decisive action this time. Hopefully, if inflation starts to subside in coming months as we expect it to do, there will be no need for a further policy rate hike in H2. However, we consider it more likely than not that the MPC will raise the policy rate again in August, and perhaps in Q4 as well. If inflation proves harder to dislodge than we expect, that will mean a higher policy rate at the end of the year.