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Policy rate unchanged for the time being

The Central Bank (CBI) policy rate will remain unchanged at 1.0% for the present. According to the CBI’s Monetary Policy Committee (MPC) assessment of the short-term outlook, a weaker economic outlook and a temporary uptick in inflationary pressures pull in opposite directions. The policy rate is likely to remain unchanged until at least mid-2021.

The MPC decided on Wednesday to keep the bank’s policy interest rate unchanged at 1.0%. This is the second time in a row since May 2020, when the policy rate was lowered by 1 percentage point, that the MPC has voted to keep it unchanged.

In the accompanying statement, the MPC mentions two opposing forces: on the one hand, the weaker economic outlook caused by the accelerated spread of COVID-19 in the recent past; and on the other hand, the relatively robust GDP growth in H1/2020, together with somewhat higher inflation than was expected at the time of the last interest rate decision. Presumably, these two forces offset one another in the Committee’s assessment of economic developments and prospects since the publication of the CBI’s August forecast.

The forward guidance in this morning’s MPC statement is exactly the same as that accompanying the August decision:

More firmly anchored inflation expectations provide monetary policy the scope to respond decisively to the deteriorating economic outlook. Lower interest rates, together with actions taken by the Bank this spring, have supported domestic demand. The impact of these measures has yet to emerge in full, however, and they will continue to support the economy and facilitate a more rapid recovery than would otherwise occur.

The MPC will continue to monitor economic developments and will use the tools at its disposal to support the domestic economy and ensure that the more accommodative monetary stance is transmitted normally to households and businesses.

In our opinion, this suggests that the MPC is satisfied with the situation for the present and will probably not change interest rates in the near future unless the outlook changes markedly. In this context, Governor Ásgeir Jónsson said at today’s press conference that the impact of policy rate cuts and other measures was still coming to the fore. The full effect may not surface until the end of the pandemic approaches, uncertainty subsides, and firms begin use low interest rates as a springboard for investment.

Successful intervention strategy

At the press conference following the announcement of today’s interest rate decision, the Governor noted that the experience of the CBI’s revised foreign exchange market intervention policy, introduced a month ago, had been positive. Under the updated policy, the CBI sells EUR 3m per day in the interbank market, in addition to intervening on an ad hoc basis as it deems necessary. Ásgeir said he considered the FX market to have become more stable after the new policy was adopted.

Deputy Governor Rannveig Sigurðardóttir emphasised that the policy was in a sense a twofold measure: While the main objective of CBI intervention was to deepen the market and prevent spiral formation, the intervention policy also allowed the bank to take action if the MPC considered the ISK to have deviated too far from its equilibrium. According to the Governor, Committee members agreed that such a situation existed now. In our view, Ásgeir seemed rather firmly convinced that the ISK had some scope for upward movement further ahead, once services export revenues had begun flowing again and uncertainty had subsided. The goods account deficit was about to close, the current account was still in surplus, and the CBI’s foreign currency sales were not all that large in a broader context.

Financing the fiscal deficit: from abroad or from the CBI?

When questioned, the Governor said that issuing foreign-denominated Treasury bonds to finance part of the fiscal deficit could be a good move at this point. The terms available to the Treasury were favourable, and such issuance could generate temporary foreign currency inflows when the Treasury converted the loan proceeds into ISK. It would also reduce the Treasury’s domestic financing need.

The Governor also noted that the CBI was waiting for an increase in Treasury bond supply before embarking on large-scale bond purchases. As has previously been reported, the CBI has declared itself willing to buy Treasury bonds for up to ISK 150bn in order to keep long-term interest rates from rising in response to the Treasury’s increased financing need. The task facing fiscal policy will extend beyond the COVID-19 pandemic, in the Governor’s view. As a result, the CBI is patient and does not feel impelled to buy Treasury bonds prematurely. In his opinion, it is not inappropriate that yields should rise somewhat in response to the weaker fiscal outlook.

The Governor also noted that he did not consider it cause for serious concern that inflation was above the CBI’s August forecast. He considered the inflation spike primarily a sign of stronger-than-expected exchange rate pass-through. The outlook was for a deeper slack in the economy in coming quarters than had previously been anticipated, which in time would help bring inflation back to target.

Low interest rates ahead

In our recent policy rate forecast, we projected that interest rates would remain steady until mid-2021. The tenor of the CBI’s comments today supports that forecast. In fact, we consider the uncertainty to lie in whether rates will remain unchanged even longer than that. Furthermore, the outlook is for a relatively slow and gradual monetary tightening phase, once it begins, and we expect interest rates to remain lower in the long run than they have been in recent decades.


Jón Bjarki Bentsson

Chief economist