Inflation and interest rates ease downwards as the solstice passes

The Central Bank’s (CBI) 25-point interest rate reduction, announced this morning, was in line with expectations and forecasts. The policy rate is now 3.75%, and the outlook is for further monetary easing in the second half of the year.

Not least among the underlying factors is that inflation has begun to taper off again, and a slack in the economy looks set to develop before the year-end. Inflation measured 3.3% in June, after declining by 0.3% since May, and is likely to fall below 3.0% by the end of the year.

The CBI’s Monetary Policy Committee (MPC) announced this morning that it had decided to cut interest rates by 0.25 percentage points, lowering the key rate to 3.75%. The decision is in line with all official forecasts, including our own, although there were some expectations in the market of an even larger rate cut, as could be seen in a marginal rise in nominal Treasury bond yields when the market opened today.

The MPC statement contained little in the way of major news, and the tone was similar to that in other recent statements. The MPC is of the view that the economic outlook is still consistent with the CBI’s May forecast, albeit characterised by two opposing forces: on the one hand, the prospect of a larger contraction in tourism than was projected in May, and on the other, stronger private consumption in Q1 and leading indicators of consumption, both of which imply that domestic demand is more resilient than previously assumed. The Committee is of the opinion that inflation has peaked and will ease in the second half of the year, although further depreciation of the ISK could derail that assumption.

When asked for his opinion on exchange rate developments and the CBI’s potential responses, Governor Már Guðmundsson said the bank’s policy still centred mainly on intervening in the foreign exchange market in response to offshore ISK-related outflows, excess volatility, or one-off flows stemming from specific large investments. In this context, he mentioned Marel’s share capital increase in late May and noted that perhaps, in retrospect, the CBI should have intervened in the market at the peak. In our opinion, that would have been wise, as FX market movements were due in part to internal stock trading by resident investors.

We also share the Governor’s opinion that the weakening of the ISK in recent months is not cause for particular concern as yet. In fact, the ISK has been impressively stable since mid-June. Furthermore, tourism-generated FX revenues will peak during the summer, and the next few weeks will see substantial inflows despite the year-on-year contraction in the sector.

Further rate cuts in the offing

The forward guidance in this morning’s MPC statement changed in only one respect. Instead of the previous “the Government’s proposed measures in connection with wage settlements will pull in the same direction” (i.e., will mitigate the economic contraction), the MPC now says, “[t]he proposed fiscal easing will pull in the same direction.” Nevertheless, the Committee mentions once again that “[n]ear-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.”

As before, we expect additional rate cuts in the second half of this year. The MPC points out, and correctly so, that the decline in inflation expectations since the last policy rate decision has tightened the monetary stance in the interim. Based on our forecast (and the CBI’s) of falling inflation in H2, at a time when a slack is expected to develop in the economy, there will be ample reason to lower interest rates. We expect rate cuts totalling at least 0.5 percentage points before the end of the year.

Inflation snoozes in the summer sun

Statistics Iceland’s CPI measurement for June, published a mere five minutes after the CBI’s interest rate decision, should satisfy the MPC, as inflation has begun to fall again. The CPI rose by 0.38% month-on-month in June, lowering headline inflation from 3.6% in May to the current 3.3%. The June measurement was in line with published forecasts. We had projected a rise of 0.4% between months, whereas forecasts as a whole lay in the 0.35%-0.4% range.

The housing component contributed less to the CPI rise (0.10%) than we expected, and house prices fell marginally between months. Air transport also pushed the index upwards by less (0.11%) than we had anticipated, and restaurant prices dipped unexpectedly (-0.8%). Pulling in the other direction were recreation and culture (0.07% CPI effect), electronic equipment (0.06%), food and beverages (0.05%), and other goods and services (0.05%), all of which rose more strongly than we had projected.

We think inflation has peaked for the present and will taper off in H2/2019. We expect the CPI to remain flat in July and then rise by 0.3% per month in both August and September, leaving headline inflation at 3.4% in September. If our forecast materialises, inflation will fall to 2.9% by the end of this year.


Jón Bjarki Bentsson

Chief economist