The highlights from the MPC statement are as follows:

• Inflation measured 4.2% in April and has fallen markedly from its peak two years ago.
• According to the CBI’s newly published forecast, inflation will remain close to 4% through the year-end and then start to ease towards the target.
• The inflation outlook re­mains highly un­cer­tain, however, not least be­cause of the re­cent global eco­nomic tur­moil.
• Growth in domestic demand has subsided in line with a tight monetary stance. Ca­pa­city pres­sures in the eco­nomy have there­fore eased stead­ily, as can be seen in the cool­ing of the hous­ing and la­bour mar­kets.
• Even so, eco­nomic activ­ity still ap­pears re­si­li­ent, as is re­flec­ted, for in­stance, in re­cently pub­lished pay­ment card turnover data.
• In addition, wage costs have continued to rise briskly, and while inflation expectations have fallen, they remain above target.

The MPC’s forward guidance takes a distinctly admonitory tone – much changed since March. It reads as follows:

Although inflation has eased and inflation expectations have fallen in the recent term, inflationary pressures remain. The con­di­tions that would en­able an eas­ing of the real in­terest rate have there­fore not yet emerged. Fur­ther in­terest rate cuts will de­pend on whether in­fla­tion moves closer to the Bank’s 2½% tar­get. (our emphasis)

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

For the sake of comparison, the March statement read as follows:

Although inflation has eased and inflation expectations have fallen in the recent term, inflationary pressures remain, which calls for a continued tight monetary stance and caution regarding decisions going forward. This is compounded by significant global economic uncertainty.

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

As this shows, the MPC is determined that all else being equal, it will only lower interest rates in coming quarters to the extent that inflation declines. It is uncommon that forward guidance expressed this strongly is accompanied by a rate cut.

Weaker growth, higher inflation

The CBI’s new macroeconomic forecast, published concurrent with the interest rate decision, is somewhat more pessimistic about GDP growth and inflation than the previous forecast, released in early February. The CBI projects GDP growth at 1.0% in 2025, 2.5% in 2026, and 2.7% in 2027. It should be borne in mind, though, that year-2024 GDP growth turned out nearly a percentage point stronger in real terms than the CBI had projected in February, and that economic activity in 2025 is therefore about the same in the new forecast as in the previous one.

For 2025-2027, the CBI now expects inflation to average roughly 0.4% higher than in the last forecast. Nonetheless, the bank forecasts that it will move towards the 2.5% inflation target, reaching the target in spring 2027 if the forecast holds.

Actually, ever since the CBI began lowering the policy rate last autumn, its inflation forecasts have become noticeably gloomier. For instance, in the autumn, the bank assumed that inflation would measure 3.4% this year and 2.7% in 2026.

The CBI specifies that inflation uncertainty has mounted, not least because of unknowns surrounding developments in the trade war launched by the US administration earlier this year. The risk profile is more or less symmetric, however, meaning that the likelihood that inflation has been underforecast is roughly equal to the likelihood that it has been overforecast.

Is the monetary stance unchanged?

As is noted above, the juxtaposition of a nominal interest rate cut and no-nonsense forward guidance took us slightly aback. At the press conference following the announcement of the interest rate decision, CBI officials said they considered the MPC’s decision clear and in no way a sign that the Committee had changed tack since the March decision. In this context, it is worth recalling this excerpt from the minutes of the MPC’s March meeting.

The Bank’s real rate was virtually unchanged since the previous meeting, but the outlook was for it to rise until the MPC’s next decision date, due to continued disinflation. The Committee therefore considered it possible to lower the key rate without loosening the monetary stance. Members agreed, however, that there was a need for caution in unwinding the monetary stance, even though the positive output gap had narrowed in the recent term and inflation had eased.

As far as we can tell, the real policy rate has not risen by most measures since those minutes were published, and by some of them it has actually fallen. The statement from the MPC’s March meeting was one of the key reasons for our forecast of an unchanged policy rate this time. It would seem, then, that the Committee’s assessment changed somewhat in the interim.

The long interval until the next rate-setting meeting appears to have played a role in the MPC’s decision to lower the policy rate today. The next decision date, in August, is a full three months from now. We think such a long hiatus unfortunate and unnecessary, especially because of the hope that uncertain situations such as the trade war and the outlook for the forthcoming winter tourism season will grow somewhat clearer in the next few months. It would be better to shorten the interval between the Committee’s third and fourth meetings of the year.

Continued rate cuts probable in the autumn

As is mentioned above, the MPC stated quite explicitly that further policy rate reductions would hinge on continued disinflation. Actually, CBI officials were even more plainspoken at the press conference, stating that further rate cuts would require a significant decline in inflation. In our opinion, this is suboptimal messaging, given that the MPC is supposed to be forward-looking, and later in the year, temporary factors (such as a depreciation of the ISK or price hikes abroad) could easily push measured inflation higher, at a time when other factors (such as expectations and economic developments) might provide the scope for a reduction in the real rate.

Although the CBI’s own inflation forecast does not give cause to expect the MPC to lower the policy rate again before well into the coming winter, we think it probable that conditions for additional rate cuts will develop later this year. Our preliminary forecast is for additional policy rate cuts totalling 0.5 percentage points in H2, leaving the CBI’s key rate at 7.0% by the year-end. Interest rates could even fall somewhat more before the turn of the year, if clear signs that a slack in the economy is opening up should emerge. More rate reductions are in the cards for 2026 as the economy cools and inflation tapers off.