In November, it emerged that the policy rate would probably have been raised had it not been for the uncertainty stemming from the seismic activity on the Reykjanes peninsula. The MPC’s forward guidance in November read as follows:

Although the effects of recent interest rate hikes are coming more clearly to the fore, the poorer inflation outlook suggests that it may prove necessary to tighten the monetary stance still further. In spite of this, the MPC has decided to keep the key interest rate unchanged, owing to uncertainty about the economic impact of seismic activity on the Reykjanes peninsula. As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

Since then, there have been significant changes in a number of the factors the MPC takes particularly into account in its decisions. The following is a summary of the likely drivers of the February interest rate decision.

Considering that wage agreements may well be settled in the very near future and a rate hike now could put a cat among the pigeons, and that the MPC’s late-March interest rate decision is not far off, we think it likeliest that the Committee will decide to keep rates unchanged this time. A rate cut next week is unlikely, though, given that inflation expectations are as high as they are and that a few prominent uncertainties – including how the aforementioned wage agreements turn out and what form the Grindavík support measures ultimately take – remain in the foreground.

The economy is cooling

There are clear signs that demand pressures in the economy have subsided in recent quarters and will continue to ease in the coming term.

In our most recent macroeconomic forecast, we have sketched out the scenario that we think represents the likeliest path economic developments will take in 2024-2026. After surging in 2021-2022, GDP growth started to lose steam in 2023, plunging from 7.0% in Q1 to 1.1% in Q3. In Q3, domestic demand contracted year-on-year as well, for the first time since the pandemic year 2020. Growth in Q3 was due almost entirely to stronger services exports and a contraction in imports.

GDP growth appears to have been weak in Q4/2023 and its composition broadly as in Q3. We estimate GDP growth for 2023 as a whole at 3.0%,with 1.9% growth to follow in 2024. This is weak in historical context, and the year actually marks a turning point in the business cycle, although a YoY contraction is not in the cards. Intrayear developments will probably mirror those in 2023, with exports the main driver early in 2024 and consumption and investment to gain momentum later in the year.

For 2025, we forecast GDP growth to rise to 2.6%, owing mainly to faster growth in consumption and investment. Growth in goods exports is set to resume as well, while services export growth will ease.

The outlook is for 2.9% GDP growth in 2026, with growing domestic demand outweighing weaker export growth. Stronger growth in investment and private consumption further ahead will stem not least from firms’ greater capacity for investment, with falling interest rates and robust real wage growth accompanying declining inflation.

Inflation on the wane

We can say with assurance that the unexpected month-on-month plunge in the CPI in January and the steep decline in twelve-month inflation were exceedingly welcome to most, as wage negotiations are at a sensitive stage and the first interest rate decision of 2024 just around the corner. In addition to this, inflation was lower than expected in December, and the short-term outlook for twelve-month inflation has therefore changed markedly for the better since the last interest rate decision. It should also be noted that most, if not all, measures of underlying inflation fell significantly in January.

Twelve-month inflation measured 6.7% in January and has therefore eased noticeably after peaking at over 10% early in 2023 and averaging 8.7% for the year as a whole. Inflation looks set to fall fairly quickly in coming months, mainly because imported inflation and house price inflation are both lower than before. If our forecast for coming quarters is borne out, twelve-month inflation could average 6.2% in Q1/2024 and 5.2% in Q2. For comparison, the CBI projected in November that it would measure 6.8% in Q1 and 5.7% in Q2. The main near-term uncertainties are house prices and the ISK exchange rate, which must remain stable if the premises underlying our forecast are to hold.

Our baseline forecast does not assume that inflation will fall to the 2.5% target during the forecast horizon. We project that it will average 5.2% this year, 3.2% in 2025, and 3.0% in 2026. This puts it very close to the target in the latter half of the horizon.

The ongoing wage negotiations are one of the main uncertainties in our medium-term inflation forecast. In our macroeconomic forecast, we presented simplified alternative scenarios providing, on the one hand, for a 5.0% wage rise in 2024 and a modest increase in the years to follow, and on the other, wage developments broadly in line with those in the past few years. In comparison, the baseline forecast assumes a 6.5% increase in wages this year and somewhat slower wage growth in the two years to follow.

The scenario exercise shows that inflation could fall back to the CBI’s target quite quickly if the more optimistic scenario is borne out and that, conversely, it would take longer to bring inflation to target if the pessimistic scenario carries the day. Naturally, this would also change the policy rate outlook, as is discussed in more detail below. It is worth stressing that these scenarios represent a simplified picture, although we do think they give a rough idea of the impact wage agreements could have in the coming term.

Erratic inflation expectations

Recent surveys indicate that households’, executives’, and market agents’ inflation expectations are still quite high. In fact, expectations rose by various measures in the most recent surveys, after declining in the previous ones. But it is worth bearing a few factors in mind when interpreting these measurements:

·         The most recent measures of household and corporate expectations date from before the turn of the year, and they may well reflect the autumn pause in disinflation more than the favourable developments in the past two inflation measurements.

·         A new market expectations survey was carried out early last week (22-24 January). At that time, measures to resolve Grindavík residents’ housing problems had just been announced, and shortly before then, discord about wage negotiations surfaced among leading groups in the Icelandic Federation of Labour and the Confederation of Icelandic Employers. Furthermore, the highly favourable January CPI measurement had not yet been published.

That said, persistently high inflation expectations give genuine cause for concern and are perhaps one of the strongest reasons for a tighter monetary stance at present. On the other hand, it can be said that the inflation outlook and the tendency of long-term expectations to fluctuate in line with short-term developments reflect how weakly long-term inflation expectations are anchored to the target.

Under such conditions, it is riskier to overinterpret such measurements, which can fall as quickly as they rise, as we have seen in the past. Expectations are therefore less of a leading indicator and more of a reflection of past inflation and other factors than they might be otherwise – a phenomenon known as adaptive expectations in English. In Icelandic, a term like rear-view-mirror expectations [is: baksýnisspegilsvæntingar] gives an accurate picture of the situation.

Under circumstances like these, the CBI can actually respond in two ways:

• it can tighten the monetary stance until inflation expectations reflect the inflation target, other factors be damned.
• Wait until other determinants start to affect expectations and focus instead on managing long-term expectations once external conditions (and/or the impact of monetary policy on other determinants) have moved expectations closer to the target.

The latter option, of course, is not ideal if short-term developments and prospects are not conducive to lower expectations. In our opinion, however, it is reasonably likely that factors such as a more stable ISK, declining foreign inflation, reduced demand pressures in the economy, a more balanced housing market, and relatively moderate wage agreements could contribute to more favourable short-term developments in inflation, which would probably show fairly clearly in lower long-term inflation expectations. Of course, many of the factors mentioned above are clear evidence of the growing impact of tight monetary policy, even though that policy has yet to harness long-term inflation expectations firmly enough.

To cut a long story short, we think choosing the latter of the two options described above is more sensible than focusing overmuch on bringing long-term expectations down no matter what, possibly causing monetary policy to be unnecessarily tight further ahead.

When will interest rates start falling?

It is impossible to state with certainty that the CBI’s monetary tightening phase is a thing of the past. As is noted above, it emerged in November that the policy rate would probably have been raised at that time had it not been for the uncertainty stemming from the seismic activity on the Reykjanes peninsula.

But the outlook has changed in recent weeks and months. Inflation has eased significantly, inflation expectations have fallen by some measures, signs of a contraction in domestic demand have grown clearer, and there is still the possibility of wage agreements consistent with fairly rapid disinflation.

We therefore think it most likely that the tightening episode is over and that the policy rate will be unchanged until the spring. If inflation falls and demand pressures in the economy subside as we have assumed in our macroeconomic forecast, monetary easing could begin this spring. It will start gradually, though, and the policy rate will remain high in coming quarters. We project that the policy rate will be lowered to 8.0% by end-2024 and 6% at the end of 2025, reaching 5% as the forecast horizon draws to a close. Presumably, long-term interest rates will fall gradually at the same time.

But unless everything lines up pretty neatly, interest rate cuts could be longer in coming; furthermore, the possibility of further rate hikes in coming quarters cannot be ruled out. For instance, if the pessimistic scenario described above is borne out, the policy rate could be a full 1 percentage point higher, on average, over the forecast horizon. Conversely, if the optimistic scenario materialises, average interest rates could be lower than in the baseline forecast by 1 percentage point or more.