Not the last word from the Central Bank

The Central Bank (CBI) held a press conference today to discuss recent monetary policy actions pertaining to Treasury bond purchases, and to present an analysis of two scenarios illustrating the possible economic impact of the COVID-19 pandemic in Iceland. It was the third extraordinary meeting the Bank has called in two weeks.


Thórarinn G. Pétursson, the CBI’s Chief Economist, presented two different scenarios illustrating the severity of COVID-19’s impact on the economy. The scenarios indicate that GDP growth could be negative by between 2.4% and 4.8% this year, before adjusting for the large-scale mitigating measures announced by the Government a few days ago.

In spite of this massive shock, the CBI does not project major changes in the inflation outlook in the two scenarios. Thórarinn said this was because of the countervailing effects of various forces; for instance, the ISK is weaker in the scenarios than in the CBI’s February forecast, yet prices abroad have fallen steeply. Furthermore, domestic inflationary pressures will ease significantly as a result of increased unemployment and underutilisation of capacity.

In spite of this massive shock, the CBI does not project major changes in the inflation outlook in the two scenarios. Thórarinn said this was because of the countervailing effects of various forces; for instance, the ISK is weaker in the scenarios than in the CBI’s February forecast, yet prices abroad have fallen steeply. Furthermore, domestic inflationary pressures will ease significantly as a result of increased unemployment and underutilisation of capacity.

Colossal blow to tourism

Tourism features prominently in the scenarios. In the “milder” scenario, the number of tourists visiting Iceland is expected to decline by 37% year-on-year, which corresponds to a 14% contraction in goods and services exports. In that scenario, the epidemic will be short-lived and the summer season will be weak but not hopeless. In the bleaker scenario, the YoY decline in tourist visits measures 55%, which corresponds to a 21% contraction in goods and services exports. In this example, the epidemic lasts longer and the recovery is considerably slower.

In 2019, nearly 2 million tourists visited Iceland. It is obvious that this year’s total will be well short of that. As Iceland’s largest export sector by far, tourism is enormously important for the country’s GDP growth. It is clear that the sector will be hit by this crisis, but it is less clear just how hard the blow will be.

The scenarios assume that private consumption growth will be negative by 1.1-3.8%. We at Íslandsbanki Research consider this forecast relatively optimistic, and we expect a slightly stronger contraction in private consumption this year. The ban on gatherings and the steep drop in tourist arrivals over the next several months will have a profound impact.

The scenario analysis assumes that unemployment will range between 5.7% and 7% this year. During the Great Financial Crisis, unemployment peaked at 7.7% in 2010, but the CBI pins great hopes on the so-called part-time option, which provides for payment of partial benefits to workers who reduce their employment percentage because of COVID-19.

To be sure, the uncertainty level attached to scenarios of this kind is unusually high at present, and conditions are changing very rapidly. Even so, the scenario analysis is most welcome. The CBI still plans to issue its next macroeconomic forecast concurrent with the May issue of Monetary Bulletin.

Authorisation for ISK 150bn in Treasury bond purchases

Also at today’s press conference, Governor Ásgeir Jónsson discussed the quantitative easing (QE) programme the CBI intends to embark on by buying ISK-denominated Treasury bonds. The authorisation for such purchases totals ISK 150bn, or about 5% of GDP. Ásgeir emphasised that detailed arrangements for the purchases were not yet complete but would be prepared in cooperation with the Ministry of Finance and the Government.

The aim of the QE programme is to prevent long-term bond yields from surging in tandem with the Treasury bond issuance that is needed to finance the response to the current situation. The CBI has not used QE to date, but in doing so it can affect long-term yields, just as the policy interest rate is intended to affect short-term yields. Ásgeir noted that with this, the CBI had gained a new long-term policy instrument.

Not the CBI’s last word

It is uncertain what actions the bank will take next, but CBI officials’ willingness to put their money where their mouth is and take action as needed can only be viewed as positive. “We’re just getting started,” said the Governor a week ago, and this morning he said that these latest measures were not the bank’s last word on COVID-19. He said he considered the actions taken by the Government and the CBI to have prepared the economy to withstand the ongoing crisis, thereby largely obviating the need for further depreciation of the ISK.

Authors


Bergthora Baldursdottir


Analyst

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Bjorn Berg Gunnarsson


Director

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