One member voted against the June rate cut

The MPC lowered the policy rate by 25 basis points at it last meeting, held in June, and has slashed rates by a total of 75 bp so far this year. Four Committee members voted in favour of the June rate cut, with one member dissenting and preferring to keep rates unchanged. In coming to its decision, the MPC took account of several factors: the economic contraction could prove more protracted than previously expected, inflation expectations had fallen since the previous interest rate decision, and inflation looked set to subside to the 2.5% target this year.

Little change since the last MPC meeting

The economy has been relatively quiet since the MPC’s last rate-setting meeting, apart from a slight appreciation of the ISK in July. The outlook is still for an economic contraction this year, although inflation expectations have subsided and the inflation outlook has improved. The Committee has stated that near-term monetary policy decisions will depend on the interaction between developments in economic activity, on the one hand, and inflation and inflation expectations, on the other.

We think this indicates strongly that the MPC is ready to lower rates still further, starting with a 25-bp reduction next week.

New Central Bank Governor

The upcoming interest rate decision will be noteworthy in that Ásgeir Jónsson has now taken the helm as Governor of the CBI and will preside over his first MPC meeting in that capacity. Ásgeir has said in interviews that further rate cuts in the near future are a possibility.

Economic contraction still expected this year

The CBI issued its last macroeconomic forecast in May. That forecast was considerably bleaker than its predecessor, published in January, which nevertheless provided for a brief and mild contraction this year, followed immediately by robust GDP growth in 2020. The CBI will publish its updated forecast on 28 August, concurrent with the interest rate decision.

According to our macroeconomic forecast from June, we expect this year’s contraction to be sharper than the CBI projected in May. Factors that reinforce our opinion include our forecast of a steeper decline in tourist arrivals than the CBI has assumed. According to figures from the Icelandic Tourist Board and Isavia, tourist arrivals were down 17% in July and 13.4% in 2019 to date. The CBI’s forecast provided for a downturn of only 10.5% between years. In the wake of this contraction, total foreign payment card turnover has contracted year-on-year, although turnover per tourist has risen somewhat. On average, each tourist spends more in Iceland than before, potentially cushioning against the blow dealt by the reduction in visitor numbers.

The CBI also published an alternative scenario providing for a steeper reduction in tourist arrivals this year, and in view of recent developments, we think it likely that this scenario will carry the day. The MPC appears to share our opinion on this, as at its last meeting it did discuss the possibility of a longer, stronger economic contraction than had been assumed in May. Because of the contraction that lies ahead, we think it likely that the Committee will lean towards lowering the policy rate rather than keeping it unchanged.

Inflation expectations continue to fall

At the time of the last interest rate decision, the most recent inflation measurement, 3.6%, was from May. Inflation has fallen markedly since then, measuring 3.1% in July, and we expect it to fall even lower in coming months. In addition, the ISK had weakened slightly just before the last rate-setting meeting, but things are different now, as it started to appreciate in July. Since the last interest rate decision, it has appreciated by about 2.4% against the euro.

The MPC mentioned in June that declining inflation expectations in the market could provide scope for further rate cuts.

Corporate and market inflation expectations have fallen significantly in just a few months. According to the most recent measurements, they have fallen by virtually all measures since the last survey, which was conducted in May. Market agents’ one-year inflation expectations have fallen from 3.5% to 2.95% this year, and three out of four survey respondents consider the current monetary stance too tight or far too tight.

We think these metrics suggest strongly that the MPC will lower the policy rate at its upcoming meeting.

Another rate cut likely this year

Given the improving inflation outlook and the economic contraction expected this year, we forecast that the MPC will lower the policy rate again before the year-end. The most important factors in the decision will be how much the economy cools and how strong cost pressures from public sector wage agreements prove to be.

Based on our inflation forecast and the growing need for monetary easing while the economy rights itself, we think it quite likely that the MPC will lower the policy rate by another 25 bp this year. Thereafter, we expect interest rates to remain steady through 2020.

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