2021 – “the year of money printing”?

Notably, the forward guidance in the MPC’s last statement has been changed this time, in that the phrase specifying that Treasury bond purchases would be used to support a more accommodative monetary stance has been deleted.

The new version reads as follows:

The MPC will apply the tools at its disposal to support the domestic economy and ensure that inflation eases back to the target within an acceptable time frame.

The November statement included the following forward guidance (our emphasis):

The MPC will continue to use the tools at its disposal, including Treasury bond purchases by the Central Bank, to support the domestic economy and ensure that the more accommodative monetary stance is transmitted normally to households and businesses.

Governor Ásgeir Jónsson’s comments at the press conference following the interest rate announcement also suggest that the CBI has shifted its focus as regards money printing: that instead of buying Treasury bonds in large amounts so as to keep long-term interest rates low and boost the money supply, it will buy euros from the Treasury for the same purpose. Therefore, “the year of money printing”, as the Governor called 2021 at a meeting last autumn, will not necessarily be a year of large-scale Treasury bond purchases.

The Republic of Iceland issued a bond in the amount of EUR 750m very recently, and it intends to use some or all of the proceeds to the Treasury deficit. Presumably, the Treasury will deposit the proceeds to its FX account with the CBI, whereupon the CBI will draw down its FX balance and increase the Treasury’s ISK balance at a predetermined exchange rate. Then, when the Treasury uses the ISK from the account to pay its expenses, these brand-new krónur will be put into circulation.

The impact on long-term interest rates and the general economy should be comparable, as the Treasury’s domestic issuance will be correspondingly lower.

Forecast rapidly subsiding inflation, persistent unemployment

According to the new issue of Monetary Bulletin, GDP growth is forecast to pick up over the course of 2021 and be robust in the years to come. The CBI projects it at 2.5% in 2021, 5.1% in 2022, and 4.1% in 2023. The bank specifies, however, that economic developments will depend largely on how successful efforts to control the pandemic prove to be, both in Iceland and elsewhere. In comparison with our own recent macroeconomic forecast, the CBI assumes that GDP growth will be weaker this year but considerably stronger in the two years to follow. It should also be borne in mind that last year’s estimated contraction in GDP is smaller in the CBI’s forecast than in ours.

In comparison with the CBI’s November forecast, its new forecast assumes a bleaker outlook for exports but stronger growth in domestic demand. The bank expects both investment and private consumption to grow more rapidly this year than was previously projected. Interestingly, the CBI forecasts a modest contraction in residential investment this year and moderate growth in 2022. There has been much discussion recently of whether new residential construction is declining quickly at present, causing a bottleneck in the market. Weaker growth in exports is due in part to the CBI’s downward revision of expected tourist numbers. The bank now projects that about 700,000 tourists will visit Iceland this year, which is in line with the baseline scenario in our macroeconomic forecast.

The CBI’s inflation forecast is virtually identical to our own: inflation is set to fall quickly this year and measure just below the 2.5% inflation target in 2022 and 2023. The bank notes that inflation expectations have remained relatively stable and that inflationary pressures will subside quickly, as there is considerable slack in the economy and the ISK will tend to dampen inflation rather than being the inflation trigger we have seen in recent quarters.

The CBI’s unemployment forecast is considerably more pessimistic than our own, and it has been revised downwards since November. The bank now expects registered unemployment to average 10.2% of the labour force this year, 8.3% in 2022, and 6.5% in 2023. If these projections materialise, economic policy’s most important task further ahead must surely be to create jobs – at a time when the authorities may well be faced with more severe and more varied problems relating to long-term unemployment than it ever has before. But as is mentioned above, we think the CBI is too pessimistic on this score, as unemployment could fall swiftly once sectors as labour-intensive as tourism and construction recover.

Tersely worded forward guidance, but unchanged rates likely throughout 2021

When queried, the Governor said he was not of the view that the MPC’s forward guidance should be more explicit. Neither did he want to exclude the possibility that the monetary stance would be tightened in coming quarters if the economy should spring back to life – particularly if fiscal policy were still strongly stimulative at the same time.

As before, the MPC appears to be reluctant to signal clearly where monetary policy conduct is headed in coming quarters, and actually, apart from the summary of Monetary Bulletin, today’s statement was all but skeletal. In the current uncertainty phase, we think it would be preferable if the MPC were to state more clearly when, or under what conditions, policy rate hikes might be forthcoming. Actually, the same applies to the specifics of potential money printing.

Nevertheless, we remain convinced that the policy rate will be unchanged through the year-end, unless tourism and domestic demand gain that much more traction later in the year. Conversely, if the economic recovery suffers a severe setback concurrent with falling inflation, the possibility of a further rate cut cannot be ruled out, either.