The MPC has been divided in all three of its interest rate decisions thus far in 2024. Each time, four of its five members have voted in favour of Governor Ásgeir Jónsson’s proposal to hold the policy rate unchanged, and the fifth member has dissented, voting instead to lower interest rates by 0.25 percentage points. The dissenter has always been the Deputy Governor for Financial Stability, first Gunnar Jakobsson and then, on the most recent occasion, the acting Deputy Governor, Arnór Sighvatsson.

It is worth noting that the 21 August interest rate decision will see another change in the MPC, when the new Deputy Governor for Financial Stability, Tómas Brynjólfsson, takes a seat on the Committee for the first time. It will be interesting to hear his take on the matter.

In May, the MPC’s main arguments in favour of leaving the policy rate unchanged were as follows:

• The positive output gap in the domestic economy appeared to be larger than previously estimated.
• The outlook was for inflation to fall more slowly than previously expected, and inflation expectations remained too high.
• Although the monetary stance was tight and economic activity had subsided, domestic demand was still relatively strong.
• Furthermore, there was still considerable strain on capacity, and indicators of a slowdown in the labour market were not unequivocal.
• Furthermore, recent wage rises and fiscal measures could support demand.
• There was the risk that companies would pass pay rises through to prices to some extent, at a time when there was still an output gap.
• The household saving rate had proven higher than previously thought, which could cause private consumption to pick up sooner; therefore, the monetary stance would have to be tighter than would otherwise be needed, given how persistent inflation had been.
• It was still unclear whether overall demand for housing had eased, and in addition, the rise in house prices could have a ripple effect and stimulate domestic demand, not least because inflation expectations were high.
• It would be riskier to lower interest rates too soon than to hold them unchanged for the present.
• It was important to begin lowering interest rates at a credible point in time because even a relatively small reduction in the Bank’s key rate could have a strong impact on expectations, as it would signal the start of a monetary easing phase.

The main arguments in favour of a rate cut in May were these:

• Activity in the tourism industry had begun to ease, which would affect the housing market.
• Furthermore, the impact of recent cost increases on the price level had receded.
• The rise in goods prices had lost pace, and global commodity prices had fallen year-on-year, which probably had yet to show more clearly in Iceland.
• Mortgage interest rate reviews were in the offing for a large number of households, which could support the monetary stance.
• The underlying real rate was therefore higher than generally assumed (if one looked past the temporary effects of supply shocks on house prices, and therefore on the CPI) and would continue to rise over the summer months.

The following is a summary of the chief points we expect the MPC to weigh and measure as they tee up the August interest rate decision.

 How fast is the economy cooling?

A range of statistics published since the last interest rate decision suggest a distinct cooling of the economy that will last through the year-end. We have recently discussed data and leading indicators that support this conclusion in one way or another, whether in connection with exports or domestic demand. These include a year-on-year decline in passenger departures from Keflavík Airport in Q2, a drop in both the Gallup Consumer Confidence Index and the big-ticket index of planned major purchases, sluggish growth in payment card turnover, and a downturn in both the Analytica Composite Leading Indicator (CLI) and the results of Deloitte’s survey among large companies’ chief financial officers. In addition, collections agency Motus has reported a marked increase in arrears among households and businesses in recent months, which it believes “could be a predictor of more widespread financial distress ahead.”

But this trend is not unambiguous. The Icelandic Tourist Board has just published its tally of passenger departures via Keflavík Airport in July, which shows a slight YoY increase – the first one since March. In addition, Gallup’s spring survey of corporate expectations showed an uptick in optimism relative to the survey beforehand. This is striking in view of the Deloitte survey, which was carried out at about the same time but gave markedly different results. Other findings – for instance, on worker shortages and staff recruitment plans – indicated that labour demand could subside in coming quarters.

On the whole, it appears to us that the outlook is for weak GDP growth in 2024, and a number of factors suggest that our 0.9% growth forecast from May was firmly on the optimistic side. In Q1/2024, GDP contracted by 4% YoY, and while the capelin catch failure was a major driver of that result, the figures also indicate that the economy has shifted from expansion to an adjustment phase.

The CBI forecast in May that GDP growth would measure 1.1% this year. The bank’s new forecast will be published in Monetary Bulletin concurrent with the 21 August interest rate decision, and we would not be surprised if the GDP growth forecast were revised downwards. By the same token, the estimate of the output gap in the coming term could conceivably reflect reduced demand pressures, which would tip the scales towards a policy rate cut.

Headline inflation has been persistent …

In May, the MPC was of the opinion that even though inflation and inflation expectations had fallen, indications that inflationary pressures were subsiding to a sufficient degree had not yet come clearly enough to the fore. Presumably, developments in inflation since then have been a disappointment for the Committee, as they have been for us and most others. The July inflation measurement, which will be the most recent one available to the MPC at the time of next week’s decision, was above published forecasts. Headline inflation measured 6.3% in July, 0.3 percentage points higher than at the time of the May policy rate decision. Most measures of underlying inflation also showed an increase in July.

Although recent developments in inflation are doubtless a thorn in the MPC’s side, there are a few factors that brighten the picture somewhat. Part of the nearly 0.5% rise in the CPI in July was due to irregular items such as the seasonal spike in airfares, a sizeable increase in food and beverage prices, and shallower summer sales than we often see in the month of July. These could all reverse to a large degree in SI’s next CPI measurement. Furthermore, the first imputed rent measurements using the new methodology have resulted in slower increases than the previous method would have given. And finally, it should be borne in mind that, as the chart above indicates, the trend in both measured and underlying inflation is still on a fairly firm downward path, as it has been since H2/2023, in spite of the setback in July.

Despite the July hiccup, we expect inflation to keep falling in the coming term. According to our recently published forecast, inflation will be just over 6% until the autumn but will fall to 5.3% by the year-end and to 3.4% one year from now. Furthermore, it should be borne in mind that the forthcoming change in taxes on petrol and diesel motor vehicles could cause the fuels and lubricants item in the index to fall steeply at the turn of the year, with a marked downward impact on the inflation measurement. It is still uncertain, though, whether the change will have this effect, and if so, it will only affect twelve-month inflation in 2025.

… and inflation expectations are high

Just like inflation itself, measures of inflation expectations have been persistently above optimal levels. The five- and ten-year breakeven inflation rate in the bond market, for instance, is just over 4%. The implied five-year breakeven rate five years ahead has actually risen since the CBI’s policy rate decision in May, and the MPC pays close attention to this measure of long-term inflation expectations as they are priced in the bond market.

But as before, it is worth noting that the breakeven inflation rate includes an uncertainty premium and is therefore not solely a reflection of inflation expectations. The premium reflects uncertainty about long-term real returns on investments in non-indexed bonds – uncertainty that does not exist in the case of indexed bonds. The premium has probably risen in the recent term, alongside an increase in uncertainty about developments in inflation. In essence, then, there could be a long wait ahead if the MPC wants to see the long-term breakeven rate rub elbows with the 2.5% inflation target again, as it did at the beginning of the 2020s. All this said, it certainly gives cause for concern that the breakeven rate should be as high as it is these days, as it is difficult to square such a high rate with moderate inflation.

The MPC will have in hand the most recent market expectations survey, as it usually does when Monetary Bulletin is published concurrent with an interest rate decision. Furthermore, new measurements of corporate and household inflation expectations will be published before the end of this quarter. Like the breakeven inflation rate, households’, businesses’ and market agents’ long-term inflation expectations have been persistently high in recent quarters, which gives cause for real concern. But it is worth remembering that when inflation expectations become less firmly anchored to the target in the first place, long-term expectations start to reflect recent developments and the short-term outlook more than they would otherwise. This has two types of implications:

• First of all, it makes it harder for the CBI to bring inflation back to target, as this monetary policy transmission channel becomes clogged, which calls for a higher real policy rate for a longer period of time than would otherwise be needed. CBI officials have pointed this out repeatedly.
• Second, the CBI cannot rely as strongly on measures of long-term expectations as indicators of whether it is timely to start unwinding the monetary stance. In other words, long-term expectations are likelier to chase inflation and short-term expectations than to be directly affected by interest rate policy, at least in the near future. In a situation like this, it can be more fruitful to consider shorter-term expectations instead.

Developments in short-term inflation expectations appear to show a more decisive downward trend than long-term expectations do. Actually, households’ one-year expectations appear to reflect current inflation almost without exception. On the other hand, corporate and market expectations one year ahead, as well as the two-year breakeven inflation rate in the bond market, show a steady, determined downward trajectory dating back to Q2/2023. If this trend continues, it can be argued that some reduction in the policy rate should follow suit; otherwise, the real policy rate will probably climb higher by most measures. It will be interesting to see whether new measures of short-term inflation expectations continue to fall despite this summer’s uptick in measured inflation, as appears to be the case with the short-term breakeven rate.

The real policy rate is quite high

The real policy rate has risen significantly in the past two years. In terms of the simple average of measures of expected inflation, the real policy rate flipped from being negative by 2.5% in spring 2022 to being positive by nearly 4% according to the most recent measurements. Long-term real rates in the market have surged as well. For example, the yield on indexed Treasury bonds with a ten-year duration was 0.5% in March 2022 but is currently around 2.7%.

According to the minutes from the MPC’s May meeting, the Committee was of the opinion “that the monetary stance was probably sufficient and that it was fairly likely that the stance would grow tighter in coming months, even if interest rates were held unchanged.” The minutes also state as follows:

“On the other hand, indications that inflationary pressures were subsiding to a sufficient degree had not yet come clearly enough to the fore. Of particular concern was the fact that inflation expectations remained significantly above target. For this reason, it would be riskier to lower interest rates too soon than to hold them unchanged for the present. It was also important to begin lowering interest rates at a credible point in time, as even a relatively small reduction in the Bank’s key rate could have a strong impact on expectations, as it would signal the start of a monetary easing phase. Future policy decisions would be determined by developments in inflation and inflation expectations in the coming term, as it was important to maintain an appropriate policy stance.”

Here it is worth asking whether the MPC is forward-looking enough in determining the monetary stance, and what requirements a “credible point in time” would have to satisfy. Presumably, this credibility refers to the emergence of clearer signs of reduced inflationary pressures than we have seen recently. If this is a prerequisite, it is unlikely that a majority of Committee members have changed their minds since May, when they considered it too soon to lower the policy rate.

Rate cut before the year-end?

Similarly, it is not certain that the MPC will be convinced that the “credible point in time” has arrived when it meets for the final two interest rate decisions of 2024. That will depend on whether signs of a cooling economy grow stronger as winter closes in, and whether inflation and inflation expectations move closer to the target before the year-end. According to our macroeconomic and inflation forecast for the quarters ahead, there should be a good chance of a rate cut before the turn of the year. In this context, we reiterate the tried-and-true adage, “Slow and steady wins the race”, which in our opinion applies equally to monetary policy conduct in Iceland.

As time passes, we expect the monetary easing phase to gain steam as inflation falls and the economy cools.

We forecast that the nominal policy rate will be 9.0% at the end of 2024, 8.0% in mid-2025, and below 7% by the end of 2025. The easing phase could end approximately two years from now, with the policy rate around 5.5%, provided that GDP growth is modest over the period and inflation has begun to approach the CBI’s target in late 2025.