In June, the MPC voted unanimously in favour of Governor Ásgeir Jónsson’s proposed 1.0-point rate hike, as it had in May. One member, Gylfi Zoega, would have preferred to raise rates by 1.25 percentage points but acceded to the Governor’s proposal. According to the minutes from the June meeting, the Committee also discussed a rate hike of 0.75 percentage points, although apparently there was limited support for it.

The main arguments in favour of the larger step in June were these:

• The real rate had fallen since the last interest rate decision – despite a nominal rate hike – and was negative by a wide margin.
• The policy rate was well below the equilibrium real rate, indicating that the monetary stance was still considerably accommodative.
• It would be necessary to withdraw this support with nominal rate hikes, although a decline in inflation expectations could also affect the real rate.
• The rise in inflation expectations during the lead-up to the decision gave real cause for concern, and a rate increase would be conducive to bringing expectations closer to the target once again.
• The resilience of the domestic economy could be seen in strong demand for housing and rapidly rising house prices.
• The labour market was quite tight, job numbers had risen swiftly, and unemployment had given way to a labour shortage.
• The risk of wage drift was greater because it could prove more difficult than before to address the labour shortage with imported workers.

The main arguments for taking the smaller step were as follows:

• The global economic outlook had deteriorated, and the outlook was for a slowdown in trading partners’ GDP growth.
• Optimism had waned among households and businesses, both in Iceland and elsewhere.
• A share of the increase in private consumption was due to the repercussions of the pandemic, as consumers were tapping accumulated savings.
• The economic outlook in Iceland could therefore turn around more quickly than anticipated.
• The interactions between CBI rate hikes and the application of macroprudential tools could prompt a more abrupt slowdown in house price inflation and domestic demand growth than would otherwise occur.

In our opinion, the following factors will be uppermost in MPC members’ minds as they consider the August interest rate decision.

Slack in the economy has closed, but outlook is cloudy

The Icelandic economy has by and large recovered from the economic shock it sustained at the onset of the COVID-19 pandemic. Thus far, increasing domestic demand has been the main driver of economic growth since it turned positive in Q2/2021. Exports have been gaining ground steadily, however, and we think they will be the mainstay of growth in coming quarters.

The outlook is for GDP growth to be considerably stronger in Iceland than in other advanced economies, both this year and next. There are several reason for this:

• The rapid recovery of tourism, which weighs heavily in Iceland’s goods and services exports – and in the economy as a whole.
• Weaker economic impact (direct and indirect) of the Ukraine war than is generally seen in Europe.
• Last but not least, most Icelandic households’ and businesses’ generally strong financial position despite the pandemic-related headwinds of the past two years.

Various indicators suggest that most Icelandic households are well positioned at present. Unemployment is broadly back to the pre-pandemic level, the labour participation rate has rebounded, demand for housing is strong, and payment card turnover growth has been buoyant in recent quarters.

But not all the news is good. Real wages have deteriorated in 2022 to date, and consumers are more pessimistic about the economic and labour market outlook than at any time since mid-2020. These factors, plus interest rate hikes and tighter borrower-based measures imposed by the CBI, are likely to dampen Icelanders’ zeal for consumption in H2/2022.

Indicators relating to the business community paint a similar picture. With a growing labour shortage and bleaker sentiment expressed in expectations surveys at a time when operating expenses are rising and trading partner countries’ growth prospects are dimming, many companies are likely to postpone investments and run their operations more cautiously in the coming term. Furthermore, uncertainty about the coming winter’s wage agreements will probably amplify these effects for both households and businesses.

To make a long story short, the slack in the economy appears to have closed, and in some sectors an output gap has opened up, yet demand growth is likely to lose considerable momentum in the coming term even if the CBI should hold off on further policy action.

High inflation: a multi-headed monster

If the CBI’s anti-inflationary measures have made an impact to date, they have been outweighed by other factors. In July, headline inflation soared to a nearly 13-year high of 9.9%. At this juncture, a sizeable share of it is due to rising house prices, but as an examination of various measures of inflation shows, inflationary pressures are widespread. For instance, inflation according to the CPI excluding housing measured 7.5% in July. Furthermore, imported inflation has risen steeply, and domestic cost pressures are strong in the manufacturing, retail and wholesale trade, and services sectors.

Twelve-month inflation does not look set to subside to any marked degree before next year. As 2022 progresses, however, imported price pressures will ease steadily, and according to our forecast, house price inflation will lose steam as well. Over the course of 2023, we expect both of these to develop more closely in line with the CBI’s inflation target. Domestic cost pressures will remain strong, however.

The outlook can be described as follows: we think it highly likely that inflation will be cut in half – to roughly 5% – in the next twelve months or so. That said, it could prove harder to halve it again and reach the CBI’s 2.5% inflation target in the near future. In that arena, domestic costs – which are driven to a large extent by expectations – will be a major factor.

High inflation expectations a thorn in the side of the MPC

As it generally has in the past, the MPC paid close attention to inflation expectations when it set interest rates in June. The minutes from the June meeting show this clearly:

Committee members stressed that the recent rise in inflation expectations was cause for genuine concern but noted that higher interest rates would help to bring inflation and inflation expectations closer to the target once again.

That being the case, more recent measurements of inflation expectations will give the MPC little cause for cheer. Obviously, short-term expectations among households, businesses, and market agents reflect the currently high headline inflation rate, as can be seen in comparable expectations surveys taken abroad. But long-term inflation expectations have risen steadily in recent quarters and are now generally above the inflation target. It should be borne in mind, though, that expectations of high inflation in the immediate future push the five- and ten-year averages upwards, even though inflation might prove more palatable further ahead.

Developments in the breakeven inflation rate in the bond market tell a similar tale. For instance, our calculations suggest that the five-year breakeven rate five years ahead – that is, the five-year average inflation rate market agents project for 2027 and beyond, plus an uncertainty premium – is now around 4%. Presumably, some of that figure is due to uncertainty about real yields on nominal Treasury bonds – uncertainty that could actually be quite considerable at the moment, given the very cloudy inflation outlook. But the big picture is this: the breakeven rate in the bond market most likely indicates inflation expectations that are out of sync with the attainment of the CBI’s 2.5% inflation target within an acceptable time frame.

Real policy rate still low

Even though the nominal policy rate has risen by 4.0 percentage points since May 2021, bringing the real policy rate into positive territory has proven a more arduous task. It emerged in June that the strongly negative real policy rate in spite of the recent nominal policy rate hikes was a major factor in the decision to heave interest rates so sharply upwards at that time. That rate hike certainly delivered an increase in the real policy rate by some measures, but by most criteria the monetary stance is still quite accommodative.

On a related note, according to the result of a recent survey among financial market participants, 2/3 of respondents judged monetary policy to be insufficiently tight although this ratio did decline by 10 percentage points compared to the last survey in April.

It has come to light, both in the MPC statement from June and in public statements made by the Governor and other MPC members since then, that the monetary stance will have to be tightened still further if inflation is to be brought back to target within an acceptable time frame. With this in mind, and in view of developments since the last policy rate decision, it is difficult to avoid the conclusion that a hefty rate hike will be needed in August.

Further interest rate hikes in the pipeline

We think it likely that the MPC will prefer to front-load the tightening phase in an attempt to bring the real policy rate closer to some sort of equilibrium sooner rather than later. At first, nominal rate hikes will be the only factor at play, but hopefully, over the course of next winter, disinflation and more moderate inflation expectations will help push the real policy rate upwards. The upcoming round of wage negotiations also complicates matters somewhat, and the CBI could do something it has sometimes done before at such times: refrain from raising rates further but issue a stern warning that the outcome of the negotiations will affect interest rates thereafter.

We project that the policy rate will be raised by at least another half a percentage point before the end of the year – probably in October. This would bring the policy rate to 6% by the year-end. Thereafter, we expect the policy rate to remain unchanged until mid-2023, with disinflation and falling inflation expectations providing additional monetary tightening in the interim. Hopefully, conditions enabling a gradual unwinding of the monetary stance will be in place by H2/2023. But in view of developments in recent quarters, it has to be said that the uncertainty in our forecast is concentrated on the upside: the tightening phase could end at a higher interest rate level and the subsequent easing could be delayed longer than we have projected.