Monetary Policy Committee: Consensus lacking on unchanged policy rate

One of the Central Bank (CBI) Monetary Policy Committee’s (MPC) five members wanted to lower the policy rate in March, as was the case in February. The next few weeks could prove eventful and might determine whether the CBI starts lowering interest rates in May. It is increasingly likely, though, that rates will be held unchanged until late summer, at least.

According to the newly published minutes from the MPC’s March meeting, the Committee was not unanimous in its decision to hold rates steady. As in February, Gunnar Jakobsson, Deputy Governor for Financial Stability, disagreed with the other Committee members and wanted to lower the policy rate by 0.25 percentage points. The other four members voted in favour of Governor Ásgeir Jónsson’s proposal to keep the policy rate unchanged.

As the table indicates, at the last six rate-setting meetings, opinion among MPC members has been divided more often than not. The last unanimous decision was in November 2023, when the recent evacuation of the town of Grindavík and the uncertainty about further seismic activity on the Reykjanes peninsula eclipsed other factors that might have affected the decision.

The MPC’s main grounds for its March decision were as follows:

  • Inflation and inflation expectations were still high.
  • Although growth in domestic demand had slowed in the recent term, indicators implied that it remained strong.
  • Firms had scaled their hiring plans upwards again, the share of firms reporting staffing shortages was still high, the labour market was still tight, and unemployment was low.
  • Housing market activity was still strong, and house prices had risen in the recent term.
  • There was a reasonable probability that 2023 GDP growth had been underestimated in the most recent data, as previous figures had been revised substantially and the newest figures should therefore be interpreted with caution.
  • Even though the recent signing of long-term wage agreements was a positive development, there was some risk that firms would pass a large share of the wage hikes through to prices, as had happened at the beginning of 2023.
  • It was not yet clear how fiscal measures would be financed, what impact they would have on demand, and whether the fiscal stance would ease.
  • A high real rate was still needed to ensure that inflation would not remain persistent for a protracted period of time.
  • The risk that the monetary stance was too loose to bring inflation back to target within an acceptable time frame was still greater than the risk that it was too tight.

Gunnar Jakobsson’s rationale for lowering the policy rate was as follows:

  • The situation was similar in most respects to that prevailing at the previous meeting, but uncertainty had diminished because of the signing of benchmark-setting private sector wage agreements.
  • The real rate had continued to rise rapidly, and households’ and businesses’ situation had tightened.
  • The effects of previous interest rate hikes had yet to emerge.
  • In view of the current situation and the data available to the Committee, it was appropriate to begin lowering the policy rate incrementally.

The majority opinion as expressed in the minutes is worth noting. It reads as follows:

“Unambiguous indications that inflation was clearly on the decline would have to emerge in order to make it possible to lower interest rates, and it was important to begin the monetary easing phase at a credible point in time.”

This statement can be interpreted in a number of ways. For example, inflation (at 6.8% in March) is down by one-third from its local peak a year ago, and measures of underlying inflation have also moved in the right direction in the interim. On the other hand, disinflation has hit the wall recently, with the hefty rise in the CPI in February and March. Presumably, MPC members are focusing on developments from the past few months and expectations for the months immediately ahead.

What has transpired since the last interest rate decision?

Although only a short time has passed since the last interest rate decision, and even though the Easter holidays made their imprint on both the market and the publication of statistics, the past few weeks have not been entirely free of new developments:

  • March inflation figures exceeded expectations; the CPI rose 0.8% month-on-month, and headline inflation is now 6.8%.
  • House prices rose considerably, affecting the March CPI measurement, and Grindavík residents’ demand for housing appears to have made a palpable impact on the property market.
  • Bond yields have risen, as has the short-term breakeven inflation rate.
  • New data from Bílgreinasambandið (the Icelandic association of motor vehicle sales and service entities) show a continued contraction in new motor vehicle registrations by individuals and companies alike. This gives an indication of developments in private consumption, as well as in car rental agencies’ investment during the prelude to the peak tourist season.
  • The CBI announced this morning that it had decided to increase credit institutions’ fixed reserve requirement from 2% to 3% of the reserve base. All else being equal, this should tend to tighten the monetary stance in the future.

What could happen between now and the next interest rate decision?

The CBI’s next interest rate decision, scheduled for 8 May, is just over a month away. Developments in the next few weeks will presumably determine whether or not the monetary easing phase will start at that time. The factors we take into account in this context include the following:

  • The April inflation measurement could be the deciding factor. Given the MPC’s majority opinion as described above, a favourable CPI measurement and a sizeable decline in twelve-month inflation would be needed in April if the majority is to change its mind in May. The CPI rose by 1.3% MoM in April 2023. Our preliminary forecast for April 2024 assumes a MoM increase of 0.6% in the CPI, which would lower headline inflation to 6.1%. Whether this will be enough to cause a change in the majority opinion in May will depend on whether measures of underlying inflation and inflation expectations decline as well, and on developments in the factors listed below.
  • Most of the groups whose contracts are still outstanding may have finalised new wage agreements by the time of the May decision. If these wage agreements are in line with those already concluded, an interest rate cut will be more likely.
  • The Government’s fiscal strategy plan will be introduced in the next few weeks. In this case, it is very important whether, and how, increased Government spending due to Grindavík and the wage agreements is addressed, so that the fiscal stance will not loosen in comparison with previous fiscal strategy plans and budgets.
  • The summer tourist season for 2024 will take shape. Many large foreign entities will finalise their bookings for accommodation, recreation, and the like in April, and it should then grow clearer whether concerns about dwindling demand for travel to Iceland are justified.

As before, our preliminary forecast, prepared just after the last interest rate decision, provides for a slow and gradual monetary easing phase starting in May. We have to acknowledge, however, that we think the newly published MPC minutes increase the probability that rate cuts will not start until later this year. The interval between the May decision date and the one immediately following – 21 August – is quite long. It therefore appears increasingly likely that Icelanders will have to hold out until summer’s end, at least, before rate cuts begin.


Jón Bjarki Bentsson

Chief economist