The CBI announced this morning that the MPC had decided to raise the CBI’s policy rate by 1.0 percentage points. It is the largest single increase to date in this segment of the monetary tightening phase, which started last June. The key interest rate – the rate on seven-day term deposits – is now 7.5%, its highest since spring 2010. The policy rate has now been raised by a total of 6.75 percentage points in just under two years.
Hefty policy rate hike, but slightly less stringent tone
A worsening inflation outlook and strong demand pressures in the economy weighed heavily in the Central Bank’s (CBI) decision to raise the policy rate by a full percentage point. But even though the rate hike was a large one, the forward guidance in the Monetary Policy Committee’s (MPC) statement was somewhat more moderate than in February. The policy interest rate is now 7.5% and could rise somewhat higher between now and mid-year.
Today’s increase was larger than had generally been forecast. Analysts from all of the commercial banks, ourselves included, projected a rate hike of 0.75 percentage points. We believed a one-point increase was possible, but we thought a half-point increase was in the picture as well.
Economy running hot, with widespread inflationary pressures
According to this morning’s MPC statement announcing the interest rate decision, “[i]nflationary pressures are still growing, and price increases are becoming ever more widespread.” The statement goes on to say, “Long-term inflation expectations are still well above target, and the Bank’s real rate has declined since the MPC’s last meeting. The outlook is for inflation to be higher in the near future than was forecast in February, even though the housing market has cooled.”
The MPC then points out that year-2022 GDP growth was above the level the domestic economy could sustain in the long run. Furthermore, indicators implied that domestic demand was stronger in early 2023 than had previously been anticipated, and the labour market was very tight.
At the press conference following the interest rate decision, it came to light that the MPC had wanted to take a decisive step this time so as to bring inflation and inflation expectations under control. Time would tell whether further action would be needed. In February, uncertainty about how strongly the newly landed wage agreements would affect the price level was one factor that prevented the MPC from raising the policy rate more than it did. The Committee had subsequently concluded, however, that these cost effects would indeed pass through to inflation to a large degree.
Turbulence abroad not a matter of great concern
When questioned, Governor Ásgeir Jónsson and Deputy Governor Rannveig Sigurðardóttir said they were not deeply concerned about the impact the international banking schemozzle would have on the Icelandic economy. Icelandic households and businesses carried relatively modest amounts of debt, and given the defences that had been erected around the banking system, problems of that type were unlikely to surface in this country.
Notably, the MPC statement made no mention of the fiscal stance, although it has frequently done so in the recent past. On this point, CBI officials said that the bank could not wait for other economic policymakers to join the fight against inflation; instead, it had to take the action it needed to take, and immediately. All assistance from the fiscal end of the table would be most welcome, however. In this context, it is worth mentioning that the Ministry of Finance and Economic Affairs is set to introduce its new fiscal plan in the next few weeks, and political leaders have intimated that it will entail a tighter fiscal stance than the previous plan did.
Furthermore, CBI officials are of the opinion that monetary policy transmission is effective and that policy rate hikes have passed through successfully to the real economy thus far. On the other hand, bringing inflation down is a bigger challenge than had previously been expected. Growth in corporate lending has gained pace recently, and the MPC was therefore more attentive to the effect interest rate policy would have on that trend. CBI officials hoped that other parties – both the labour market and the Government – would tune into this, even though they had not been mentioned explicitly in today’s MPC statement.
Are further interest rate hikes in the offing?
The MPC’s forward guidance is quite different from that accompanying the last interest rate decision. Today’s MPC statement is quite stern but stops short of expressly portending further rate hikes in the near future.
It reads as follows:
Under these circumstances, it is important to prevent a wage-price spiral, particularly in view of the strong demand pressures in the economy and the upcoming wage negotiations. The MPC will apply its policy instruments so as to ensure a better balanced economy and bring inflation back to target.
What is noteworthy here is that despite a hefty rate increase and a relatively stern tone, the MPC statement does not announce as unequivocally as in February that further monetary tightening will be needed. This could indicate that the MPC wanted to respond right away to the bleaker outlook instead of “saving up” a portion of the rate hike for the next decision, scheduled for 24 May.
We still think it likely that the MPC will prefer to bring the monetary tightening episode to a close before the long summer break between rate-setting meetings, which starts after the May decision date. As a result, the rate hike in May will probably be much smaller than the one announced today. The policy rate could therefore lie in the 7.75-8.0% range by mid-year. If our macroeconomic and inflation forecasts are borne out, the policy rate will probably be held unchanged for the remainder of the year and then start easing downwards early in 2024.