In March, the MPC voted unanimously to lower the policy rate by 0.25 percentage points. Actually, the Committee has been unanimous in all of its rate-setting decisions since last November. Before then, however, divided opinion was more common than consensus at MPC meetings.

This March, the choice lay between lowering the policy rate by 0.25 percentage points and lowering it by 0.50 points, according to the minutes of that meeting.

The Committee’s main rationale for a larger rate cut was as follows:

• Inflationary pressures from the housing market had subsided.
• Services inflation had eased, and inflation excluding housing had been close to target in recent months.
• Although the real policy rate had been unchanged between meetings, it looked set to rise in coming months as inflation lost pace.
• As a result, there was scope to lower the CBI’s key interest rate without easing the monetary stance.

The main arguments for a smaller rate cut were:

• Caution would be needed in relaxing the monetary stance, even though demand pressures in the economy had eased in the recent past and inflation had fallen.
• Although underlying inflation was on the decline, inflation and inflation expectations remained somewhat above target.
• There were still inflationary pressures from the labour market, as could be seen in the fact that wage costs had risen in excess of the inflation target.
• A survey taken among Iceland’s 400 largest companies showed that respondents were relatively optimistic about the current economic situation and had stepped up their investment plans between surveys.
• In addition, indicators implied that households were optimistic and that their accumulated savings had continued to grow, which could suggest that households had the financial latitude to increase private consumption despite tight monetary policy.

The MPC’s forward guidance was as follows:

Although inflation had eased and inflation expectations had fallen, inflationary pressures remained. This called for a continued tight monetary stance and caution regarding decisions going forward. The situation was compounded by elevated global economic uncertainty.

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

Below is an overview of factors we expect MPC members to take into account as they consider the May interest rate decision.

Based on the above-mentioned priorities and recent developments, we think there are stronger grounds for holding the policy rate steady than for lowering it.

The economy is resilient despite high interest rates

According to indicators relating to private consumption and investment, the Icelandic economy has been quite robust in 2025 to date. For instance, households’ payment card turnover grew by 2.8% in real terms in Q1, and new motor vehicle registrations by individuals were up 59% year-on-year in the first four months of 2025. Furthermore, the Gallup Consumer Confidence Index (CCI) indicated considerable optimism among consumers in Q1, although the April measurement showed something of a setback. Strong imports of investment goods in recent months suggest that business investment is resilient, and at the same time, newly released figures from Statistics Iceland (SI) indicate that year-2024 investment was more robust than previously expected.

Most households and businesses are well positioned despite a protracted period of high interest rates. Households still have significant savings, and real wages have continued to inch upwards despite persistent inflation.

On the other hand, it is worth noting that unemployment has picked up year-to-date relative to the same period in 2024. Moreover, population growth has slowed markedly, not least because of a sharp decline in net immigration of foreign nationals in the recent past. Labour shortages have eased, according to recent surveys taken among large companies, although roughly a fourth of respondents still report being understaffed. Labour market tightness therefore appears to be easing, and the slowdown in population growth fosters a better balanced housing market.

Uncertainty about the implications of the trade war

In March, the MPC discussed the uncertainty surrounding the effects of the trade war launched by the US government this year. Since then, the US has imposed tariffs on most goods imports but has declared a postponement, until this summer, of the so-called “reciprocal” tariffs it had planned to levy on various countries in line with their goods account balance vis-à-vis the US.

Naturally, there is still major uncertainty about how the global tariff environment will play out further ahead. It appears, however, that the likelihood of higher inflation in Iceland because of the trade war has diminished. In fact, we think inflation risk would be greater if the ISK were to weaken substantially because of a setback in exports than it would be if foreign currency prices of imported were to surge. Furthermore, the trade war is more likely than not to dampen global demand, and it could mitigate the need for a tight monetary stance later on. The most recent plot twists in the trade war indicate that the US government is less committed to maintaining high tariffs for a long period of time than it implied in early April. Even so, it is well to remember that uncertainty is a thorn in the side of the MPC, and all else being equal, it is likely to discourage the Committee from changing the near-term policy stance.

Inflation intransigence

After a convincing decline in the recent term, inflation has lost some of its downward momentum in the past few months. As is noted above, the MPC expected that even though it lowered the policy rate in March, the monetary stance would not ease between the March and May meetings, partly because inflation would fall commensurably. But according to SI’s April measurement, inflation ticked upwards to 4.2% and is therefore back to where it was at the time of the MPC’s March meeting. The short-term inflation outlook has therefore deteriorated.

In the preliminary forecast we published after the release of the April inflation figures, we projected that Q2 inflation would average 3.9%. In the February issue of Monetary Bulletin, however, the CBI forecast inflation at 3.5% in Q2 and then 3.4%, on average, in the latter half of the year. It is quite likely that the CBI’s new inflation forecast, to be published in Monetary Bulletin concurrent with the forthcoming May interest rate decision, will be more pessimistic about the short-term outlook than the February forecast was.

In addition, developments in other inflation measurements are very likely to cause the MPC genuine concern. As the chart shows, various measures of underlying inflation were broadly the same in April as in February. The services inflation that the Committee mentioned in March has also risen by 0.4% since the last policy rate decision, and domestic goods prices have increased by a similar amount, doubtless due to developments in wage costs. SI’s wage index was up nearly 7% year-on-year in March – a far faster pay rise than might have been expected based on last year’s wage agreements.

Moreover, recent developments in inflation expectations and the breakeven inflation rate are unlikely to be to MPC members’ liking. Since the March interest rate decision, the short-term breakeven rate has held steady, but our calculations indicate that the long-term rate has risen by 0.1-0.2%. Presumably there are other forces at work, in addition to market agents’ inflation expectations. Given the situation in the bond market, though, it would be difficult to conclude that the monetary stance is as tight as it was before the March policy rate cut, as the MPC expected at that time.

Inflation expectations have hardly moved recently by some yardsticks, even though inflation itself fell steadily until Q1/2025. According to the most recent measurement of households’ and businesses’ expectations, published by the CBI in March, corporate executives expect inflation to average 3.5% over the next five years, while households project it at 4.0%. Both groups’ expectations were unchanged in comparison with Q4/2024.

However, according to the CBI’s newly published market expectations survey, respondents expect inflation to average 3.1% over the next five years and 3.0% over the next ten. On both measures, expectations fall from the previous survey. This is noteworthy as the bond market has, if anything indicated slightly higher long-term expectations in light of a higher breakeven rate, as mentioned earlier. Considering all of these figures together, it appears that long-term inflation expectations are still well above the CBI’s 2.5% inflation target, which will dampen the MPC’s enthusiasm for monetary easing, all else being equal.

A fairly high real interest rate is still needed

Real interest rates in Iceland have been very high by most measures in recent quarters. That said, the real policy rate has eased recently, in terms of either past inflation or expectations metrics. At the press conference following the announcement of the MPC’s March interest rate decision, CBI officials indicated clearly that they thought it most appropriate to keep the real policy rate right around 4% for the present, as long as clear signs of a slack in the economy have not yet emerged. It would therefore be quite a change of tack if the MPC were to cut the nominal policy rate further after the aforementioned developments in the real policy rate.

On the other hand, real interest rates have not softened in terms of either indexed bond yields or indexed lending terms. By that measure, the interest rate policy stance is still restrictive, after having tightened substantially from mid-2022 until well into H2/2024. In our assessment, it is precisely this increase in long-term real rates that has ultimately mitigated pressures in the housing market, incentivised saving, and curbed private consumption in recent quarters. If MPC members pay closer attention to long-term real rates than to the real policy rate, they will be more likely to deem it possible to lower the nominal policy rate incrementally before the summer holidays without running the risk of easing the monetary stance unduly.

Policy rate cuts likely to resume after summer break

Given that the economy has been unexpectedly resilient and inflation more persistent than anticipated, we think policy rate cuts will be deferred a bit longer than we have previously forecast – unless the trade war or other economic shocks chill the global economy more abruptly than appears likely at present.

Við teljum þó meiri líkur en minni á því að stýrivextir lækki á ný eftir þriggja mánaða sumarhlé Seðlabankans. Alls gerum við ráð fyrir því að stýrivextir lækki um 0,75 prósentur fram til áramóta og stýrivextir verði því 7,0% í árslok. Peningalegt aðhald minnkar þá allnokkuð þar sem við gerum ekki ráð fyrir verulegri hjöðnun verðbólgu frá núverandi gildum það sem eftir lifir árs. Verðbólguvæntingar gætu þó þokast niður á tímabilinu og aðhaldið á þann kvarða minnkað minna.

Á næsta ári eigum við hins vegar von á að minni verðbólguþrýstingur, hóflegri verðbólguvæntingar og minnkandi spenna í hagkerfinu leggist á eitt um að skapa aðstæður fyrir töluverða viðbótar lækkun vaxta. Við spáum því að stýrivextir lækki um að minnsta kosti 1,5 prósentur til viðbótar á árinu 2026 og að meginvextir Seðlabankans verði því á bilinu 5,0 – 5,5% þegar komið er fram á lokafjórðung þess árs. Hvort vextir lækka frekar eftir það veltur svo á því hvort tekst að tjóðra langtíma verðbólguvæntingar á ný í grennd við verðbólgumarkmiðið, sem og hinu hver staða hagsveiflunnar verður þegar þar er komið sögu.

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