The highlights from the MPC statement are as follows:

• The effects of monetary policy actions are coming ever more clearly to the fore.
• The real rate has risen and inflation has fallen since the MPC’s November meeting.
• Underlying inflation has eased as well.
• Indicators suggest that economic activity is subsiding faster than previously expected.
• According to the CBI’s new forecast, the positive output gap is narrowing and will give way to a slack towards the end of the year.
• The inflation outlook has improved as a result.
• Nevertheless, long-term inflation expectations have changed very little and are still above target.
• Although the labour market has calmed down, pressures remain.
• As a consequence, inflation could remain persistent.
• Furthermore, there is uncertainty about the results of the ongoing wage negotiations and about possible fiscal measures relating to both the wage negotiations and the seismic unrest in the Reykjanes area.

The forward guidance in today’s MPC statement, short and neutral, differs vastly from the stern tone taken in November

It reads as follows:

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

In our opinion, this shift in emphasis shows that the MPC is taking fully into consideration the brightening inflation outlook and the recent signs of reduced demand pressures in the economy.

Lower inflation and weaker growth in coming quarters

The CBI published an updated macroeconomic and inflation forecast in Monetary Bulletin today, concurrent with the policy rate decision. In that forecast, the CBI projects that GDP growth will be weaker in 2024 than in 2023. It now predicts a GDP growth rate of 1.9% instead of the 2.6% forecast in November. This is identical to our own GDP growth forecast, issued last week. The revision of the forecast is due mainly to weaker growth in domestic demand, private consumption in particular. According to the CBI, the GDP growth outlook is projected to change relatively little in the next two years. The growth rate will be unchanged at 2.9% in 2025, followed by a 2.7% growth in 2026, a slight upward revision from the 2.5% forecast in November.

Pressures in the labour market set to ease

There are still significant pressures in the labour market, although they have subsided in the recent term. The CBI forecasts that the situation will continue to ease. It forecasts that unemployment will measure 4.8% in 2024 and taper off over the forecast horizon, to about 3.8% by the end of the period.

The CBI uses the Statistics Iceland labour force survey (LFS), whereas ÍSB Research relies on registered unemployment according to the Directorate of Labour (DoL). The jobless rate as derived from the LFS tends to be slightly higher than registered unemployment. This could explain the lion’s share of the difference between the forecasts from the CBI and ÍSB Research. We at ÍSB Research expect unemployment to rise this year, hitting 4% during the forecast horizon.

Inflation outlook brightens

The CBI now expects inflation to fall faster than it did in November. It projects average inflation at 5.0%, down from 5.7% in the November forecast, mainly because domestic demand has fallen more rapidly in the recent past and a negative output gap is expected to open up late this year. On the other hand, the CBI expects somewhat larger pay hikes during the forecast horizon; furthermore, it now expects inflation to average 3.3% in 2025 and 2.7% in 2026. The CBI envisions that inflation will have aligned with the target in H2/2026, making this the first time in quite a while that the bank has forecast that inflation will hit the target during the forecast period.

At this morning’s press conference announcing the policy rate decision, Governor Ásgeir Jónsson said he did not think measures to assist Grindavík residents would affect the housing market and the inflation outlook enough to upend the CBI’s view of the economic outlook. He also noted that the structure of the financing of both Grindavík support measures and the Government’s involvement in wage agreements would be very important.

When questioned, Central Bank officials said that a change in the method used to measure imputed rent for CPI calculations could dilute the impact of short-term fluctuations in inflation measurements, and that it would probably be beneficial that this method will omit the direct impact of interest rate movements on the CPI.

In this context, it is worth noting that the new Monetary Bulletin mentions this specifically:

“Statistics Iceland intends to change the method it uses to measure the housing component of the CPI, which could lead to a faster-than-expected decline in inflation later this year.”

Furthermore, CBI officials said in response to questions that headwinds in the tourism industry could move the needle as regards the outlook for export growth, the labour market, and the real estate market. The CBI’s forecast assumes that 2.3 million tourists will visit Iceland in 2024, slightly below our own forecast.

When will interest rates start falling?

It is impossible to state with certainty that the CBI’s monetary tightening phase is a thing of the past. But the outlook has changed in recent weeks and months. Inflation has eased significantly, inflation expectations have fallen by some measures, signs of a contraction in domestic demand have grown clearer, and there is still the possibility of wage agreements consistent with fairly rapid disinflation.

As we stated in our newly published macroeconomic forecast, we think it highly likely that the CBI’s monetary tightening phase is at an end and that rate cuts can be expected soon. In view of this morning’s MPC statement, the CBI’s Monetary Bulletin, and the statements made by CBI officials at today’s press conference, we consider it most likely that the policy rate will be held steady until this spring. That said, a favourable outcome from wage negotiations and a credible package of mitigating measures in response to both Grindavík and the labour market situation could make it possible to lower the policy rate starting on 20 March, the MPC’s next rate-setting meeting. It will start gradually, though, and the policy rate will remain high in coming quarters. We project that the policy rate will be lowered to 8.0% by end-2024 and 6% at the end of 2025, reaching 5% as the forecast horizon draws to a close. Presumably, long-term interest rates will fall gradually at the same time.

But unless everything lines up pretty neatly, interest rate cuts could be longer in coming; furthermore, the possibility of additional rate hikes in coming quarters cannot be ruled out. For instance, if the pessimistic scenario described in our macroeconomic forecast is borne out, the policy rate could be a full 1 percentage point higher, on average, over the forecast horizon. Conversely, if the optimistic scenario materialises, average interest rates could be lower than in the baseline forecast by 1 percentage point or more.