Since the May policy rate decision, the long-term breakeven rate in the market has risen. As of 20 June, the two-year rate was 3.6%, the five-year rate 4.0%, and the five-year rate five years ahead 4.1%. It is worth repeating that in a relatively shallow and homogeneous bond market like Iceland’s, the breakeven inflation rate should be interpreted with a considerable dose of caution.

Long-term inflation expectations still high

One way to figure out the degree to which the breakeven rate reflects factors other than inflation expectations is to compare it against survey findings. The CBI conducts quarterly surveys of market agents’ inflation expectations. Furthermore, Gallup, in cooperation with the Confederation of Icelandic Employers (SA), takes similar surveys of households’ and businesses’ expectations. For example, at its May meeting, the CBI’s Monetary Policy Committee (MPC) made particular note of the fact that market agents’ long-term expectations had fallen in the most recent survey, conducted early that month. The newly published results from surveys of households’ and businesses’ expectations probably give less cause for celebration, however. These two groups’ long-term expectations are unchanged from the survey carried out in Q1/2025: company executives still expect inflation to average 3.5% over the next five years, and households project it at 4.0%

Actually, both groups’ two-year expectations were unchanged as well, at 3.5% and 4.0%, respectively. Households’ one-year expectations fell from 5.0% to 4.3% in the most recent survey, however, while executives’ one-year expectations were 4.0%, as in the previous survey. As these numbers indicate, neither households nor businesses appear to share market agents’ increased optimism about the near-term inflation outlook.

In fact, market agents’ more upbeat sentiment as depicted in the CBI’s most recent survey doesn’t quite line up with their pricing of inflation risk in the bond market. As is noted above, the long-term breakeven inflation rate has hardly budged in the recent term, yet five- and ten-year expectations have fallen over the past six months. The discrepancy could be due to either a higher uncertainty premium or other market conditions, but it certainly draws attention.

The real policy rate is high but has crept downwards

According to the minutes from the MPC’s May meeting, the real policy rate had held broadly steady at 4% in the recent term, which was considered sufficient to bring inflation back to target; therefore, the MPC was convinced it could lower the nominal policy rate by 0.25 percentage points without materially changing the monetary stance. It is therefore interesting to examine recent developments in real interest rates.

Our calculations suggest that in terms of various measures of the short-term inflation outlook, the real policy rate is currently between 3.1% and 4.1%. According to a simple average of these measures, the real policy rate has fallen by 0.7 percentage points year-to-date. Given that the nominal policy rate was lowered by 1 percentage point over the same period, it appears that the monetary stance has loosened a bit since the turn of the year, and it looks to be on the low side of the MPC’s 4% benchmark real policy rate. But even so, the policy stance is still quite tight.

It is also interesting to compare the policy rate with long-term inflation expectations, even though it is somewhat like comparing apples to oranges as regards the time frame. There we can see a trend similar to that for the short-term rate, although the monetary stance is tighter because, in spite of everything, long-term inflation expectations are more favourable than short-term expectations are.

Our calculations suggest that based on a simple average of long-term expectations, the real policy rate is currently 3.9%. At the beginning of the year, it was 5.0% by that measure, so it can be said that the policy stance has eased more or less in line with nominal policy rate cuts.

On the other hand, the real market interest rates as measured by indexed Treasury bond yields have remained high. By that measure, the three-year real rate is now 4.1% and the ten-year rate 2.9%. Real rates by both of these measures have risen 0.2-0.3 percentage points, indicating that the policy stance in terms of real interest rates on inflation-indexed debt has not eased thus far in 2025. This can also be seen in rates on financial institutions’ indexed mortgage loans, which to a large degree are priced based on market rates.

Is the last policy rate cut of the year behind us?

As is noted above, overall developments in inflation expectations will surely be of some concern to the MPC when it meets again in mid-August. That said, it should be remembered that factors other than inflation expectations also carry some weight in the estimation of the need for monetary restraint at any given time. On the other hand, there are few arguments to support the idea that tight monetary policy is sapping the strength of the economy at the moment.

According to the newly published findings from the survey of Iceland’s largest firms, most executives consider the economic situation relatively good at present, and those who are upbeat about the outlook six months ahead outnumber those who are pessimistic. Fishing company executives stand out in sharp relief in terms of pessimism, which is understandable in view of plans to sharply increase taxes on the sector at a time when the total allowable catch for groundfish is expected to decline between years.

Private consumption is resilient, as can be seen in recent payment card turnover data, the year-to-date increase in households’ new motor vehicle registrations, and the surge in overseas travel. All of this is fostered in part by stronger real wage growth, a relatively robust labour market, and accumulated savings.

And finally, the outlook for the peak tourist season has improved recently. Although the year started weakly in the sector, April and May turned out reasonably strong in historical context. The winter ahead remains uncertain, however, and it could prove challenging for the tourism industry.

In our recent inflation forecast, we projected that inflation would hover around 4%, the upper deviation limit of the CBI’s inflation target, for the remainder of this year. In this context, it is worth noting the forward guidance from the MPC at its last meeting: that further policy rate cuts would de­pend on whether in­fla­tion moved closer to the target.

In our response to the May policy rate decision, we stated that despite the rather peculiar mix of a rate cut and a stern admonition about the need for a tight policy stance, we expected the MPC to lower the policy rate by another 0.5 percentage points in H2/2025. But given the developments outlined above, we now think the likelihood of further rate cuts this year is receding – that is, unless inflation and inflation expectations fall decisively in coming quarters or the economic outlook worsens substantially.