Inflation clinging tenaciously to the upper deviation threshold

Twelve-month inflation has hardly budged since the May decision. At that time, the MPC had in hand data from April, which showed a headline inflation rate of 4.2%. By July, that 4.2% had dipped to 4.0%, the number MPC members will have in front of them at next week’s meeting. As we explain in our new inflation forecast, we at ÍSB Research see no prospect of a near-term decline in inflation. In fact, we forecast that it will pick up in the months ahead and measure 4.4% at the year-end, but we do expect it to fall below the 4% deviation threshold at the beginning of 2026.

According to the CBI’s May inflation forecast, inflation will average 4% for the remainder of the year and then start moving slowly towards the target. The MPC statement from the May meeting includes the following: “Although inflation has eased and inflation expectations have fallen in the recent term, inflationary pressures remain. The conditions that would enable an easing of the real interest rate have therefore not yet emerged. Further interest rate cuts will depend on whether inflation moves closer to the Bank’s 2.5% target.”

Actually, CBI officials were even more plainspoken at the press conference following the announcement of the May decision, stating that further rate cuts would require a significant decline in inflation. Given the CBI’s inflation forecast, further rate cuts were not even in the running unless inflation fell faster than the forecast assumed.

Developments in other inflation measurements are also quite likely to cause the MPC genuine concern. As the chart indicates, underlying inflation was higher in July than in May by all measures. Services inflation has risen as well, owing mainly to developments in wage costs. Statistics Iceland’s (SI) wage index rose by 8.2% in the twelve months to June 2025.

Inflation expectations still high

Inflation expectations are also quite high. The breakeven inflation rate in the bond market has more or less refused to fall in tandem with the 1.75% drop in the policy rate since last autumn. When the CBI began unwinding interest rates, the two-year breakeven rate was around 3.7%, the five-year rate 3.8%, and the ten-year rate 3.9%. As of this writing, the two-year rate is 3.4 and the five- and ten-year rates are both 3.9%. As these figures show, the two-year rate has indeed eased slightly, but the five- and ten-year rates have either risen or held steady. As always, though, it must be borne in mind that the breakeven inflation rate includes a risk premium.

Gallup’s most recent corporate and household inflation expectations surveys were conducted in May and June 2025. According to the results, long-term inflation expectations were unchanged relative to the previous survey, carried out in Q1/2025. Company executives still expect inflation to average 3.5% over the next five years, while households project it at 4.0% over the same period. These two groups’ expectations about average inflation over the next two years were unchanged between surveys, at 3.5% for executives and 4.0% for households. On the other hand, households’ one-year expectations fell from 5.0% to 4.3%, although corporate expectations held steady at 4.0%.

According to the CBI’s newly published market expectations survey, they now anticipate slightly higher inflation over the coming quarters compared to the previous survey conducted in May. At the same time, inflation expectations for the next 1, 5 and 10 years have not changed much between the surveys. They expect 3.4% inflation next year, 3.0% over the next five and ten years.

Considering all of these figures together, it appears that inflation expectations are still well above the CBI’s 2.5% inflation target, which certainly must dampen the MPC’s enthusiasm for monetary easing, all else being equal.

Robust economic activity despite high interest rates

Since the May interest rate decision, the national accounts for Q1/2025 have been published, together with SI’s revision of national accounts data stretching back a number of years. According to SI’s preliminary figures, GDP growth measured 2.6% in Q1/2025. This is a stronger growth rate than the CBI forecast in May, even considering that SI revised year-2024 GDP growth figures. Domestic demand appears quite resilient, and recent data such as payment card turnover, new motor vehicle registrations, and overseas travel indicate undimmed appetite for consumption. It therefore seems that the economy is rolling along at a goodly pace despite high interest rates.

When will interest rates be lowered?

The MPC has mentioned that the real policy rate has held steady at 4% recently, and that this was a rate that would be sufficient to bring inflation to target. The real policy rate in terms of past inflation is about 3.4% and have slightly decreased since May, when they were approximately 3.6%. Based on inflation forecasts for the months ahead, the outlook is for a lower real rate by that measure. As is noted above, neither the breakeven inflation rate nor inflation expectations have declined in tandem with policy rate cuts; instead, they have remained broadly where they were at the time of the last decision. In view of this, it is unlikely that the MPC will ease the monetary stance next week.

In its May statement, the MPC said point-blank that further policy rate cuts would depend on whether inflation moved closer to the Bank’s 2½% target. But given the developments outlined above, we think further rate cuts this year unlikely – that is, unless inflation and inflation expectations fall decisively in coming quarters or the economic outlook worsens substantially. We now expect the policy rate to remain unchanged at 7.5% through the year-end. It should start to fall again in 2026, but probably at a relatively slow pace unless the economic outlook deteriorates markedly.

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