When it met last, in May, the MPC raised the policy rate by 1.0% in a unanimous decision and struck a firm tone in its statement, noting, among other things, that the MPC considered it likely that the monetary stance would have to be tightened even further in coming months so as to ensure that inflation eases within an acceptable time frame. We think it probable that the Committee will consider rate hikes ranging from 0.5 percentage points to a full percentage point before settling on a 0.75-point increase.

GDP growth outlook relatively favourable

The Icelandic economy is chugging along at a good pace after the pasting it took when the COVID-19 pandemic started to spread worldwide. According to preliminary figures from the Q1/2022 national accounts, published recently by Statistics Iceland (SI), GDP grew in real terms by 8.6% year-on-year during the quarter. Even though these are preliminary numbers, they indicate nevertheless that the economy has picked up strongly and that the effects of the Corona Crisis are receding. Unemployment has fallen rapidly and is now back to its pre-pandemic level, and payment card turnover data tell a similar tale of Icelanders’ consumption patterns.

The near-term economic outlook remains uncertain, however, as Russia’s invasion of Ukraine will undeniably affect the global economy in coming quarters. For example, the International Monetary Fund (IMF) revised its global GDP growth forecast sharply downwards in its April forecast, largely because of the direct and indirect effects of the war. For Iceland, the IMF forecasts considerably weaker GDP growth than local forecasters do, as can be seen in the chart above.

Inflation still rising

The MPC pays close attention to measures of long-term inflation expectations, and according to the minutes of its May meeting, the main grounds for raising the policy rate included the rise in inflation expectations by all measures and the elevated risk that expectations had become unmoored from the inflation target. While there has been little in the way of new expectations surveys since the last MPC decision, it is fair to assume that with the deterioration of the inflation outlook, these concerns will certainly not have receded. At the time of the last interest rate decision, headline inflation measured 7.2%, and MPC members expressed worries about both current inflation and the darkening outlook.

Inflation now measures 7.6% and looks set to rise even further in coming months. The CBI’s May forecast assumes that it will peak at around 8% in Q3, but we expect it to rise even higher. In our recent inflation forecast, we project that inflation will measure 8.4% in June, peak at the end of the summer, and then taper off slowly and steadily.

To be sure, rising inflation is due in part to price hikes abroad, which are beyond the CBI’s control. But a large share of domestic inflation is attributable to rising house prices, and the CBI can certainly affect demand for housing by raising interest rates and tightening lending rules. The CBI’s Financial Stability Committee (FSN) announced yesterday that it has tightened borrower-based lending rules even further. According to the FSN’s press release, the purpose of the measure is to safeguard the resilience of borrowers and lenders.

Although rising house prices certainly play a major role in pushing the CPI upwards at present, the MPC also keeps tabs on underlying inflation. Inflationary pressures are relatively widespread these days, which should give the MPC cause for genuine concern. For example, inflation according to SI’s core indices (which exclude various volatile items) ranges between 4.1% and 7.7%.

Negative real policy rate

Even though the nominal policy rate has been raised by 3.0% since May 2021, the real policy rate is negative by all measures. The real policy rate in terms of inflation has considerable ground to cover before it returns to positive territory, as the chart below illustrates. In terms of other metrics such as inflation expectations and the breakeven inflation rate, however, positive territory is closer at hand. Therefore, the monetary stance is still quite accommodative, and it looks as though even further rate hikes will be needed to bring about the required tightening.

As a consequence, we think it highly likely that the CBI’s monetary tightening phrase is nowhere near at an end, as the bank presumably wants to push the real policy back above zero sooner rather than later. The CBI will probably prefer to take decisive action, for if it responds too late, it might prove necessary to raise interest rates more than would otherwise be needed. Just how high the policy rate must rise during the current tightening phase depends in no small part on whether, and how much, other economic policy makers such as the Government and the social partners are willing to take action to reduce inflationary pressures in the coming term.

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