In March, the MPC accompanied its 0.25-point policy rate hike with a dose of no-nonsense forward guidance. It also came to light that two of the Committee’s five members voted against Governor Ásgeir Jónsson’s proposal, as they would have preferred to raise the policy rate by half a percentage point. The minutes from the March meeting stated clearly that a further rate hike was likely in May unless the inflation outlook improved considerably. The divided opinion among MPC members appears to have centred mainly on how quickly the Committee should respond to the past few months’ inauspicious developments in inflation and inflation expectations.

Below is a summary of some of the factors we expect to be uppermost in the minds of MPC members as they deliberate on the May interest rate decision.

In our opinion, the question is not whether but how much they will raise the policy rate on 20 May. Although we consider a 0.25-point rate hike the most likely outcome, there are strong arguments for a larger increase and a decent probability that a 0.5-point rate hike will carry the day.

The economy is cooling

Economic activity has lost steam in 2026 to date, as we have discussed in the recent past. Domestic demand growth has slowed after a strong recovery early in the decade, yet private consumption is still robust. Households’ payment card turnover suggests continued activity, although growth has lost pace since 2025 and there are signs of increased caution about large expenditures. Investment has dipped as well, especially investment in residential and commercial real estate, alongside changed conditions in the economy and heightened uncertainty in the export sector. Furthermore, households and businesses have grown far more pessimistic about the economy and the labour market in recent quarters.

The labour market shows clear signs that the tightness of recent years has unwound. Unemployment is up and a slack has begun to develop, not least because activity in tourism and related sectors has cooled. In tandem with this, immigration to Iceland has slowed markedly, and firms generally have an easier time filling job vacancies than before. In spite of this, the labour market has proven flexible, and the adjustment appears to take place more through reduced hiring than large-scale layoffs. The outlook is for unemployment to peak in H1/2026 and start to ease as the year advances. Despite the growing slack in the labour market, wages are rising quite briskly and look set to continue growing faster than is consistent with the inflation target, adjusted for productivity growth.

In the real estate market, prices increases have slowed markedly after the past few years’ steep rises. The supply of housing has grown, particularly in the case of newly built homes, and the number of months of inventory (MOI) has risen. There is still activity in the market, although turnover has subsided. In general, older homes sell faster than new builds do, and demand appears to depend more on price and location than before[AB1] .

The CBI will publish a new macroeconomic forecast concurrent with the 20 May interest rate decision. Presumably, the bank will forecast subdued growth in 2026 and a quicker pace in the years to follow, as it did in February. Even though the Persian Gulf war will probably affect the CBI’s forecast fairly strongly, we do not expect it or other recent developments to cause a material change in the bank’s assessment of the state of the real economy. The war’s impact on the inflation outlook is a horse of a different colour, however.

• Impact on the interest rate decision: A growing slack in the economy has been one of the main arguments for a more accommodative interest rate stance in the recent past, and it will probably remain so now. On the other hand, there are few indications as yet that a high policy rate is driving the economy into crisis.

Unfavourable developments in inflation

It is safe to say that the battle with inflation has grown markedly more difficult since the CBI issued its inflation forecast in early February. At that time, the bank projected that inflation would measure 5.0% in Q1, fall to 4.2% in Q2, and be down to 3.8% by Q4. The first-quarter outcome, however, was 5.2%. According to our newly published inflation forecast, inflation looks set to measure 5.2% in Q2 and average 5.0% in Q4.

 [AB1]ATH: Have I got this right?

Furthermore, underlying inflation has risen noticeably by all measures thus far in 2026, even though it tapered slightly by several measures in April. Although a large share of the worsening short-term inflation outlook can be attributed to one-off items or external factors such as the conflict in the Persian Gulf, which are beyond the scope of monetary policy, general inflationary pressures are significant as well. There is also a significant risk of second-round effects from the above-mentioned items, as inflation expectations are weakly anchored to the target.

The CBI’s inflation forecast, to be published in Monetary Bulletin concurrent with the 20 May interest rate decision, will doubtless be far more pessimistic about near-term inflation than the February forecast was. The MPC was deeply concerned about developments in inflation during the run-up to the last policy rate decision – and rightly so. Those concerns will certainly not be less pronounced now.

• Impact on the interest rate decision: Inflation and the near-term inflation outlook will tip the scales more firmly towards tighter interest rate policy than they would otherwise.

The breakeven inflation rate is high …

Rising inflation expectations were a source of major concern to the MPC in March and will presumably carry significant weight in its May interest rate decision.

We have recently discussed developments in the bond market, including the breakeven inflation rate. Among other things, we noted that the breakeven rate had risen by 0.4-0.8% in 2026 to date, mostly at the short end of the yield curve. That increase had already come to the fore at the time of the March decision, however, and since then it has been broadly unchanged – or was as of Friday 8 May.

In terms of fixed long-term Central Bank rates, it was just under 4.5% (three years), 4.3% (five years), and just over 4% (ten years). Of course, this is far above the CBI’s inflation target, but it must also be remembered that breakeven rates include a premium for uncertainty about real returns and liquidity. In our opinion, even if this is taken into account, the current breakeven rate reflects excessively high inflation expectations, and we are quite sure the MPC shares that opinion.

… and inflation expectations are bloated

Inflation expectations as depicted in opinion surveys are also higher than is desirable, based on the most recent measurements of household, business, and market expectations. These groups’ short-term expectations have fluctuated in line with increased inflation and a deteriorating near-term outlook. What is worse, however, is that long-term expectations have crawled upwards as well. For example, according to the median survey response, households expect inflation to average 4.3% over the next five years, while businesses expect it to be 4.0%. This represents a 0.3% increase for households and 0.5% for the general public since the year-end 2025 survey.

The newly published results of the CBI’s market expectations survey show that, according to the median response, market participants project inflation at 3.2% over the next five years and 3.0% over the next ten. Those expectations are therefore unchanged from February, which ought to calm the nerves of the PSN somewhat following the abovementioned increase in inflation expectations among households and company bosses.

• Impact on the interest rate decision: Together with developments in inflation itself, high inflation expectations and rising long-term expectations by some measures will put the heaviest weight on the scales in favour of a tighter monetary stance.

Continued need for relatively high real rates

In the recent past, CBI officials and the MPC have considered a real rate of 3-4% a benchmark for an appropriate interest rate stance. At the press conference in March, CBI representatives confirmed that they still used this benchmark. Furthermore, the MPC members who wanted to raise the policy rate by half a percentage point in March were of the opinion that a 0.25-point rate hike would only offset a part of the recent drop in the real rate.

The real policy rate has fallen in the recent past, and our calculations suggest that it is still on the low side in terms of forward-looking measures of inflation. By the most recent measures of inflation expectations and inflation premia the real policy rate is 2.4-3.3% by these measures and their simple average is 2.8%.

The same can be said of the long-term real rate. In terms of the indexed Government yield curve, the three-year real rate is now 3.1% and the ten-year real rate 2.8%. This represents a marginal decline in the real rate thus far in 2026. On the other hand, long-term real rates were considerably higher by that measure until this past autumn, as we have discussed recently. It is noteworthy that in a recently published expectations survey among market participants, respondents estimate the equilibrium real interest rate—i.e. the real rate that, over the longer term, would be consistent with inflation at target and output in line with potential—at 2.5% at the median. The aforementioned long-term benchmark rates are therefore not very far from that equilibrium level.

• Impact on the interest rate decision: The MPC will probably emphasise the need to increase the real policy rate and keep long-term real rates relatively high for the time being. The question is primarily whether MPC members will think they need to take a larger step now, before the summer, than they did in March.

Rate cut before the year-end?

If our newly published inflation forecast is borne out and the near-term economic outlook does not darken materially in coming quarters, the CBI will have limited scope to start unwinding interest rates in the near future. Moreover, very little would be needed to prompt another rate hike this autumn.

Our long-term forecast assumes that the policy rate will be held steady at 7.75% through the year-end. In Q1/2027, the CBI will start easing interest rates again as inflation subsides and the slack in the labour market, housing market, and general economy widens. We expect the policy rate to be lowered by 1.5 percentage points in 2027, to 6.25% at the year-end. It is highly uncertain how this will play out, however, and it depends not least on how successful the CBI is in bringing inflation expectations to heel again.

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