In February, the MPC voted unanimously to hold the policy rate steady despite the uptick in inflation since its November decision. Actually, we thought (as did others) that the Committee was calmer in February than was warranted by then-recent developments in inflation and inflation expectations. In retrospect, it would have been more appropriate to strike a sterner note in the MPC’s February statement, as the outlook has done anything but improve since then. The minutes from the February meeting suggest that there was little discussion of a rate hike at that time, although the subject was certainly broached.

To summarise, the main factors underpinning the February interest rate decision were as follows (our boldface):

·         Inflation had risen since the November decision.

·         Although the January inflation spike was due largely to changes in public levies on new motor vehicles, price increases were fairly widespread and underlying inflationary pressures remained strong.

·         On the other hand, the positive output gap in the economy had closed, and the outlook was for relatively subdued output growth and declining inflation over the course of this year.

·         In the MPC’s opinion, the labour market showed clear signs 0f cooling and the employment outlook had deteriorated.

·         Furthermore, real house prices had fallen in the previous three quarters, and rent price inflation had subsided.

·         Despite a temporary inflation spike at the start of 2026, the long-term inflation outlook was broadly unchanged.

·         The situation was highly uncertain, however, as pay rises were still sizeable and inflation expectations remained above target.

·         The MPC discussed the potential need to hold interest rates unchanged for a longer period if inflation should prove more difficult to dislodge.

·         The Committee also agreed that a rate hike might be needed if the inflation should deteriorate further, even though this could call forth a wider slack in the economy than currently forecast.

The MPC’s forward guidance was as follows:

Further decisions to lower interest rates will depend on clear evidence that inflation is falling back to the Bank’s 2½% inflation target.

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

It can be inferred from these words that in February, the MPC’s baseline scenario still centred more on when than on whether interest rates would be lowered further. Yet again, we consider this messaging unhelpful in light of the situation at that time and developments since.

Below is a summary of various factors that will probably weigh heavily in the Committee’s March decision:

It is difficult to pinpoint which of the arguments outlined above will carry the day, but on the whole, we consider the rationale for a rate hike stronger than the rationale for an unchanged rate. At the very least, a decision to keep rates unchanged would need to be accompanied by stern forward guidance.

Growing slack, yet consumption is robust

Demand pressures in the economy have receded noticeably in recent quarters, and there are widespread signs of a growing slack.

GDP growth measured 1.3% in 2025, in spite of various challenges in the external and internal environment. Growth was driven mainly by buoyant private consumption, which grew by 4.3% in real terms, and was supported by previous years’ accumulated savings and continued real wage gains. Households therefore showed considerable resilience in the face of worsening expectations, persistent inflation, and rising interest rates. Offsetting this were headwinds in the export sector – owing chiefly to a slowdown in tourism and a decline in goods exports – together with strong import growth, which reduced the contribution of net trade to output growth.

Investment grew modestly during the year – particularly investment relating to strong activity in the data centre sector – but slowed over the course of the year and contracted towards the year-end. Overall, then, domestic demand was the mainstay of GDP growth, while underlying tensions in the economy continued to sustain inflationary pressures.

ÍSB Research expects GDP growth to be tepid in 2026 and gather pace thereafter. Since we published our macroeconomic forecast in late January, prospects for exports – in tourism, metals manufacture, and the fishing industry – have actually improved somewhat. Nevertheless, we expect the slack in the labour market to keep growing and average unemployment to measure a bit higher this year than in 2025.

In addition to the labour market, changes in the housing market also reflect the growing slack in the economy. After an episode of fairly rapid house price inflation, the most recent figures imply that house prices and rent prices have started to fall in real terms. The effects of the recent tight monetary stance, which can be seen plainly, are compounded by weaker population growth and stringent borrowing requirements, both of which dampen demand.

Finally, households’ and businesses’ expectations about the economic and inflation outlook in the coming term have dimmed considerably in recent quarters. Historically, there is a correlation between developments in such expectations, on the one hand, and private consumption and corporate investment, on the other. Even so, private consumption appears more resilient thus far than mounting consumer pessimism would suggest.

Stubborn inflation and a poorer short-term inflation outlook

In recent months, inflation has developed quite differently than CBI officials envisioned at the time of the November policy rate cut. At that point, the bank projected that inflation would fall to 4.2% by Q1/2026 and 3.4% by Q2. By the time of the February forecast, the CBI had revised its inflation projections upwards to 5.0% for Q1 and 4.2% for Q2. Remarkably, this forecast revision had little impact on the MPC’s assessment of the inflation outlook further ahead, as is discussed above.

The inflation outlook has worsened even more since February. Our most recent preliminary forecast, which we published after the release of February inflation figures, assumes that inflation will measure 5.3% in Q1 and 4.6% in Q2. As before, we assume that inflation will ease somewhat in H2 but that the final leg of the trip back to the 2.5% inflation target will be an arduous journey.

Another source of significant concern is that even though one-off items such as changes in excise taxes on motor vehicles strongly affected the January inflation measurement, all measures of underlying inflation also show considerable inflationary pressures, as the chart above indicates. Furthermore, uncertainty about the short-term outlook has escalated in recent weeks, as the war between the US and Israel, on the one hand, and Iran, on the other, has caused the price of oil and related products to fluctuate wildly. Although it can be argued that central banks should generally look past inflation shocks of this kind, the CBI has less scope to do so than its Nordic counterparts, as inflation expectations are far less firmly anchored in Iceland than in neighbouring countries.

Inflation expectations on the rise

Inflation expectations have developed unfavourably in the recent term. The CBI recently published the results of its survey of households’ and businesses’ expectations, which show that expectations rose by all measures and for both groups of respondents. The increase relative to the previous survey, taken in Q4/2025, ranged from 0.3 percentage points and 1.0 percentage point. For example, corporate expectations of average inflation five years ahead rose from 3.5% to 4.0%, and households’ five-year expectations rose from 4.0% to 4.3%. In both cases, five-year expectations are at their highest since Q3/2024, after having been stable from Q4/2024 through year-end 2025, as can be seen in the chart below.

The breakeven inflation rate in the bond market has developed similarly. At the beginning of 2026, the breakeven rate both five and ten years ahead was around 3.7%. By the first ten days of March, however, the five-year rate had risen to an average of 4.3% and the ten-year rate to 4.0% Although the breakeven inflation rate captures more than inflation expectations alone, this year-to-date jump is a sign that market agents generally expect inflation to be somewhat higher in coming years than they did at the beginning of 2026.

In sum, all of these metrics imply that confidence in the inflation target is growing weaker, not stronger, which must give CBI officials cause for grave concern. As a result, it is that much more important that the MPC demonstrate its commitment to pushing inflation back towards the target sooner rather than later.

Is the current real interest rate sufficient?

CBI officials have stated recently that they consider a real policy rate of roughly 3.5% sufficient to bring inflation back to target within an acceptable time frame. According to the February 2026 issue of Monetary Bulletin, the bank estimated the real rate, expressed as the average of various measures, to have been about 3.1% during the prelude to that month’s interest rate decision.

Thus it is a thorn in the MPC’s side that the real policy rate should continue to decline at a time when inflation expectations and the breakeven rate are rising. Based on our calculations, we estimate that the real rate in terms of one-year inflation expectations and the short-term breakeven rate is a bit below 3% at present. It has tapered off by other measures as well, such as the yield on indexed Government bonds. Although the short-term economic outlook has darkened since last autumn, there must be cause for CBI leaders to contemplate whether the aforementioned real rate will suffice to bring inflation back to target, as the bank wants.

Policy rate cut this autumn?

The MPC is in a tight spot when it comes to choosing an appropriate monetary stance for an economy featuring entrenched inflation and ever more obvious signs of cooling. Based on our own expectations about economic and inflation developments, we think it likely that the policy rate will be held unchanged until Q4/2026. We hope that as inflation eases and the slack in the economy widens, the scope will develop for a series of rate cuts lasting well into 2027 and ending with a policy rate around 6%. If there are to be any rate cuts over and above this, inflation must realign with the target and/or economic developments must prove substantially more unfavourable than we anticipate.

LEGAL DISCLAIMER

This report is compiled by Islandsbanki Research of  Islandsbanki hf.

The information in this report originates in domestic and international information and news networks that are deemed reliable, along with public information, and Islandsbanki Research’s own processing and estimates at each time. The information has not been independently verified by Islandsbanki which therefore does not guarantee that the information is comprehensive and accurate. The views of the authors can change without notice and Islandsbanki holds no obligation to update, modify or amend this publication if assumptions change.  

This publication is only published for informational purposes and shall therefore not be viewed as recommendation/advice to make or not make a particular investment or an offer to buy, sell or subscribe to specific financial instruments. Islandsbanki and its employees are not responsible for transactions that may be carried out based on information put forth in the report. Before making an investment decision, recipients are urged to seek expert advice and get well acquainted with the investments market and different investment alternatives. There are always financial risks related to investment activities, including risk due to international investments and fluctuations in the exchange rate of currencies. Investors’ investment objectives and financial position vary. Past performance does not indicate nor guarantee future performance of an investment. 

The research report and other information received from Islandsbanki are meant for private use only. The materials may not be copied, quote or distributed, in part or in whole, without written permission from Islandsbanki.

This report is a short compilation and should not be considered to contain all available information on the subject it discusses. 

Supervisory body: The Financial Supervisory Authority of Iceland (www.fme.is).    

UNITED STATES

This report or copies of it must not be distributed in the United States or to recipients who are citizens of the United States against restrictions stated in the United States legislation. Distributing the report in the United States might be seen as a breach of these laws.

CANADA

The information provided in this publication is not intended to be distributed or circulated in any manner in Canada and therefore should not be construed as any kind of financial recommendation or advice provided within the meaning of Canadian securities laws.

OTHER COUNTRIES

Laws and regulations of other countries may also restrict the distribution of this report. 

Further information regarding material from Islandsbanki Research can be accessed on the following website: http://www.islandsbanki.is.