The highlights from the MPC statement are as follows:

• Indicators suggest that recent interest rate hikes have slowed overall demand growth and housing market activity.
• There are also signs that inflation expectations have begun to decline again, although they are still above the Bank’s inflation target.
• Demand appears to have been strong in Q3, although the outlook is for a slowdown as the winter advances.
• Furthermore, recent indicators from the labour market suggest that the output gap in the domestic economy has peaked.
• Moreover, the global economic outlook has deteriorated and uncertainty has grown, which could cause domestic demand to ease more quickly than previously assumed.

Doves, not hawks?

Although today’s modest increase is a clear sign of a turning point in the MPC’s interest rate policy, it is equally important that the forward guidance in this morning’s statement is quite different from that in August – and arguably neutral.

It reads as follows (changes in bold):

The MPC will continue to ensure that the monetary stance is tight enough to bring inflation back to target within an acceptable time frame. Near-term monetary policy decisions will depend on developments in economic activity, inflation, and inflation expectations. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of developments in interest rates in the coming term.

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

The MPC considers it likely that the monetary stance will have to be tightened even further so as to ensure that inflation eases back to target within an acceptable time frame. Near-term monetary policy decisions will depend on developments in economic activity, inflation, and inflation expectations. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of how high interest rates must rise.

Today’s statement is considerably milder in tone than its recent predecessors.

Present monetary tightening possibly sufficient

At the press conference following the announcement of the decision, it was noted that the CBI’s inflation forecast from August was probably too pessimistic as regards the short term. Furthermore, various indicators implied that the CBI’s interest rate hikes and tightened borrower-based measures were getting results: twelve-month inflation had begun to fall, and the housing market – an important component of headline inflation – had shifted gears. Developments in house prices, CBI officials said, were a key factor in lowering both inflation and inflation expectations.

They noted as well that the economic outlook abroad had deteriorated steadily in the recent term. As a small open economy, Iceland would always be strongly affected by economic developments in trading partner countries.

CBI officials pointed out that they had placed strong emphasis on raising interest rates rapidly in recent quarters and had indeed been ahead of most other central banks in responding to rising inflation. If inflation and inflation expectations continued to develop favourably, it might turn out that the monetary stance had been tightened enough. One cause for concern, though, was underlying inflation, which had yet to fall.

It was also mentioned at the press conference that CBI officials considered monetary policy transmission more effective and efficient than before, in that the impact of policy actions came to the fore more rapidly. This was not least because of the large share of non-indexed mortgages, whose interest burden is more sensitive to the policy rate. It could therefore be advisable to wait and see what effect rate hikes would have in the coming term before taking further action.

Furthermore, Governor Ásgeir Jónsson noted that developments further ahead – namely, fiscal policy and wage agreements – were largely in the hands of others. The results of the upcoming wage negotiations could be of major importance in this area. Ásgeir also pointed out that if labour market leaders appear in the media again and again, asserting that they want to boost wages far more than is consistent with moderate inflation, inflation expectations could rise as a result. As he has done before, Ásgeir asked all of the above-mentioned parties to join forces with the CBI to bring inflation under control.

Monetary tightening over?

We think the CBI’s monetary tightening phase has come to an end, at least for the present. In our opinion, CBI officials indicated fairly strongly that they would wait and see whether inflation and demand growth had truly turned a corner before taking further action. In addition, it will take time to bring wage negotiations to a conclusion, and presumably the MPC would also prefer to see how matters develop on that front.

If the current trend continues – i.e., if inflation falls at the rate we expect, the economy seeks a better balance, house prices rise much more slowly than in the recent past, and the coming winter proves onerous for many of Iceland’s trading partners – we think the CBI will not raise interest rates further in the next few quarters. On that score, wage agreements will also be an important factor, but it is worth remembering that the CBI’s last forecast assumed sizeable pay rises, and the MPC probably used that forecast as a reference for today’s decision. Further ahead, we expect the policy rate to start falling again as 2023 advances.