Interest rate doves and hawks

As is popular among our colleagues abroad, we reviewed the minutes from recent MPC meetings in an attempt to detect patterns in individual members’ votes. The results can be seen in the table below:

As the table suggests, the two deputy governors on the Committee have voted very differently in recent years. Rannveig Sigurðardóttir, Deputy Governor for Monetary Policy, has supported Ásgeir’s proposal at every meeting in the past three years. On the other hand, Gunnar Jakobsson, Deputy Governor for Financial Stability, has disagreed with the Governor’s proposal on six of 17 occasions since the beginning of 2021. Early on, Gunnar was more closely aligned with Gylfi Zoega and favoured a tighter monetary stance than was ultimately approved by the majority. In the past year, however, he has voted against Ásgeir’s proposal at three meetings – each time preferring a more accommodative monetary stance. Gunnar therefore appears to have established himself as the Committee’s interest rate dove in the recent term.

Furthermore, the MPC’s external members have consistently preferred a tighter monetary stance on those occasions when they have disagreed with the Governor’s proposal. This was particularly the case last October, when Herdís Steingrímsdóttir voted against the proposal to keep rates unchanged and Ásgerður Pétursdóttir noted for the record that she, like Herdís, would have preferred a 25bp rate hike even though she voted in favour of the proposal to keep rates unchanged.

The MPC’s most recent minutes explain the rationale for an unchanged policy rate in February. Here are the highlights:

• Inflation remained high and the inflation outlook had improved primarily for 2024, while the longer-term outlook had improved only marginally.
• Because the labour market was still quite tight, unit labour costs could rise more than they would otherwise.
• There was significant uncertainty about the outcome of wage negotiations.
• Government measures relating to wage agreements and the situation in Grindavík created uncertainty about the fiscal stance, as it was unclear how the measures would be financed.
• Although domestic economic activity had eased, there was still the risk that firms would to some extent pass cost increases through to prices following the wage settlements.
• Housing market activity appeared to be picking up again, and house prices had risen in the recent term.
• Long-term inflation expectations had held broadly unchanged, even though growth in domestic demand had lost pace and the inflation outlook had improved.
• It was important to bring inflation expectations down in order to ensure that inflation would realign with the target.
• In view of the high level of uncertainty, it was not a given that the monetary tightening phase was at an end, and because demand pressures still remained in the economy, it would be better to keep interest rates high for longer than to lower them too soon.

The main reasons for lowering the policy rate were these:

• The most recent data showed that the monetary stance had been sufficient in the recent past, as economic activity had subsided steadily.
• Recent developments in the economy, the inflation outlook, and the real rate suggested that the time had come to lower the policy rate.
• The Central Bank’s real rate was at its highest since 2012, and all indicators implied that it would rise considerably more in coming months.
• The risk existed that the real rate would rise more than necessary at a time of rapidly declining growth in economic activity.

What has transpired since the February interest rate decision?

Although the ink is barely dry on the 7 February interest rate decision, several things have happened since then:

• The most recent data – including payment card turnover, import figures, and passenger departures via Keflavík Airport in January – indicate that private consumption continues to shrink and that services exports will grow more slowly than previously expected.
• The Gallup Consumer Confidence Index (CCI) jumped unexpectedly in January, breaking the 100-point barrier for the first time in nearly two years. This could indicate that private consumption will pick up in coming quarters, although CCI data do fluctuate widely from month to month.
• Inflation forecasts released to date provide for a marked decline in inflation in February. We expect the CPI to rise by 0.8% in February and headline inflation to fall from 6.7% to 6.1%.
• According to the Housing and Construction Authority’s most recent capital area house price index, prices in greater Reykjavík rose 0.4% month-on-month in January, which was as we had expected and in line with the imputed rent projections in our inflation forecast.

The CBI’s next interest rate decision date is 20 March, nearly four weeks from now. The main factors that we think will inform the decision include the following:

• Wage agreements If wage agreements covering the majority of private sector workers turn out broadly in line with recent media discourse, a rate cut in March will be more likely. If contracts are still pending or provide for much heftier pay rises than are currently expected, the policy rate is more likely to be held steady.
• Tourism: It is likelier than before that the temporary headwinds in tourism caused by volcanic activity on the Reykjanes peninsula will prove longer-lasting than previously hoped. We have recently discussed the impact this could have on the domestic economy this year. If clearer signs of more sluggish growth this year come to the fore, the probability of a rate cut will increase.
• Grindavík: The Government’s newly announced measures to support Grindavík residents appear to be in line with statements made at the outset. If credible mitigating measures are introduced in the next few weeks, this will enhance the likelihood of a rate cut.
• Developments in inflation: Only one new CPI measurement – for February – will be available at the MPC’s next meeting. Continued disinflation in February and, not least, a commensurate decline in underlying inflation would make Committee members more receptive to lowering the policy rate. On the other hand, an unfavourable CPI measurement for the month will boost the chances that the MPC will hold rates unchanged.
• Real interest rate and breakeven inflation rate: The breakeven inflation rate in the bond market has fallen incrementally in recent weeks, primarily because of a drop in long-term nominal rates. At the same time, the real rate has remained high, at around 2.6% in terms of the ten-year tenor on the indexed Treasury yield curve . If this trend continues until the MPC meets again, a rate cut will be more likely, whereas a setback in the breakeven rate will have the reverse effect.

In our most recent policy rate forecast, we projected that the MPC will start unwinding the policy rate in May. We will stick with that forecast for the present. Nevertheless, the MPC minutes and the most recent economic indicators have tipped the scales towards a rate cut in March.