The MPC’s October decision marked something of a watershed, in that it was the first time in five years that two members – Gylfi Zoëga and Gunnar Jakobsson – voted against the Governor’s proposed 25-bp rate hike and wanted to raise rates by twice that amount.

Even though MPC members disagreed about the size of the policy rate increase, all agreed that rates should be raised, and their discussions focused on whether an increase of 25bp or 50bp was more appropriate.

The main arguments in favour of a 25-bp rate increase were as follows:

• Continued uncertainty about the global economic outlook
• Uncertainty about the labour market once Government support measures are unwound
• Some of the current inflation rate can be attributed to temporary factors such as foreign supply-chain disruptions
• There is considerable uncertainty about the interaction between rate hikes and the recent application of the macroprudential tools that are under the auspices of the Financial Stability Committee. The tools applied thus far include a reduction in maximum loan-to-value ratios, announced at mid-year, and the introduction of a 35% cap on most debt service-to-income ratios, announced at the end of September.
• The transmission mechanism of monetary policy is probably more efficient than before, as a higher percentage of consumer mortgages are non-indexed variable-rate loans.

The main arguments in favour of a 50-bp rate increase were as follows:

• Economic activity has rebounded strongly. On this point, MPC members cited, among other factors, steeply rising house prices, strong household lending growth, and a shortage of labour in certain sectors.
• A third of firms are having difficulty filling job vacancies.
• There is the risk of increased imported inflation in the coming term.
• Surveys show that corporate executives widely expect price hikes, both on inputs and on their own products and services.
• To quote the MPC minutes verbatim, it is “… important to tighten the monetary stance decisively, so as to minimise the risk that inflation [will] be even more persistent, and to respond strongly to the rise in long-term inflation expectations.”

The following are a few of the factors we think the MPC will discuss at next week’s meeting:

The domestic economy is recovering at a brisk pace

The post-COVID recovery appears to be moving at a decent pace, even though the pandemic itself is far from over. GDP growth measured over 7% in Q2/2021, driven mainly by a strong rebound in domestic demand. Recent indicators imply that the recovery will continue. Unemployment has fallen swiftly since the beginning of the year, measuring 4.9% in October. Expectations surveys suggest that households and businesses are generally optimistic about the economic and employment outlook. Some sectors are starting to suffer from a shortage of labour. Real wages have continued to rise despite high inflation, and households’ payment card turnover has done likewise.

Forecasts of tourist numbers in H2/2021 look broadly set to materialise in spite of fluctuations in the pandemic, and the outlook is for a steep rise in 2022, if reports of bookings with domestic tourism companies and increased flight offerings in coming quarters are any indication. And last but not least, the anticipated capelin boom could boost GDP growth by nearly 1 percentage point in 2022, with the associated impact on foreign exchange revenues, job numbers, and related indicators.

The CBI will publish its new macroeconomic and inflation forecast concurrent with next week’s interest rate decision, and MPC members will therefore have fresh data and analysis ready to hand when they meet. We think it likely that this new forecast will be noticeably more upbeat about the near-term economic outlook than the August forecast was, in part because of the prospect of a bountiful capelin season. This should support MPC members in the opinion that the economy is moving quickly towards a position where it no longer needs the support of a negative real policy rate. Even so, Committee members might prefer to take a more cautious step while the current COVID wave is passing. As is stated in the minutes from the August meeting, the MPC considered it clear “… that the link between public health measures and economic activity had weakened and that households’ and businesses’ adaptability, together with Government measures, had for the most part kept the economy moving despite the pandemic.”

Inflation outlook darkens yet again

The inflation outlook for the next few quarters has deteriorated markedly since mid-year. In our recently published inflation forecast, we project that inflation will keep climbing to a peak of 5.4% at the year-end. It will start to decline thereafter, but according to our forecast, it will average just over 4% in 2022 and will not fall back to the CBI’s 2.5% target until early in 2023.

The results of the CBI’s newly published market expectations survey sketch out a similar picture. Market participants expect inflation to average 3.6% in 2022, and according to the median response, it will not reach the target by the end of that year. In the August survey, however, market agents expected inflation to be a hair’s breadth from the target by Q3/2022, and in its August forecast, the CBI projected that inflation would align with the target soon after mid-year.

The new expectations survey does contain good news, however, in that long-term inflation expectations are unchanged from the previous survey. As before, market agents expect inflation to average 2.7% over the next five years and 2.5% over the next ten. According to this, expectations are still reasonably well anchored to the target, which should reduce the need for aggressive monetary tightening in the coming term.

Another factor the MPC takes into account is the breakeven inflation rate in the bond market, which has risen steadily since mid-August and is now in the 3.4-4.0% range, depending on maturity. On the other hand, it is more difficult than often before to interpret the breakeven rate, as Treasury yield curves are both steep and divergent at present. This could be due to temporary factors, although the uncertainty premium on nominal bond yields is probably on the high side as well. At all events, this must give the MPC some cause for concern.

Real policy rate rising gradually

To some extent, increased inflation and rising inflation expectations by some measures have mitigated the impact of the 75-bp policy rate hike on the estimated real policy rate, and therefore on the monetary stance. The real policy rate lies in a relatively wide range at the moment, depending on which measure is used, but it is quite negative by all measures, even though it has generally moved towards zero in recent months. We have sensed from statements by various MPC members that it would be more favourable to bring the real policy rate back to zero, or slightly above it, sooner rather than later, provided that the economic recovery has solidified and the slack in the economy is diminishing. Hopefully, declining inflation will help in this regard in coming months, but presumably, a sizeable increase in the nominal policy rate will be needed as well.

Further policy rate hikes on the horizon

As before, we expect the CBI to continue on its monetary tightening path in the coming term, in line with the recovery of the economy. Lower inflation further ahead should mitigate the need for rapid nominal interest rate hikes.

We expect the MPC to raise interest rates by 25bp at each of the three meetings scheduled for H1/2022, bringing the policy rate to 2.5% by mid-year. We think the pace will ease after that, with a rate hike of 25bp in each quarter until the equilibrium rate of 3.5% is reached in mid-2023. This is the level around which the policy rate will probably hover in coming years, depending on the economic climate and how close the inflation outlook is to the target.

A setback in the economic recovery – further economic sabotage by the pandemic, for instance – would be likely to slow down this monetary tightening process. The same would apply if inflation fell faster than we assume – for example, in response to a steep appreciation of the ISK and/or a slowdown in house price inflation. On the flip side, more persistent inflation could lengthen the monetary tightening phase, particularly if long-term inflation expectations become unmoored from the CBI’s 2.5% inflation target.

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