The MPC raised the policy rate by 0.25 percentage points at its August meeting, the third rate hike this year. One MPC member, Deputy Governor for Financial Stability Tómas Brynjólfsson, voted against the rate hike, however, as he preferred to hold the policy rate unchanged. In its statement from that meeting, the MPC took a far more accommodative tone than it did at the time of its March and May rate increases, in what was virtually a textbook example of a “dovish hike”. The August statement reiterated that inflation was stubborn and inflation expectations still too high, but the Committee also pointed out that underlying inflation had begun to ease by some measures and that signs of an increased slack in the economy had started to emerge. Furthermore, the sentence stressing that the MPC was ready to tighten the monetary stance further, which was included in the Committee’s forward guidance from March and May, was nowhere to be found in the August statement. We interpreted the MPC’s message as a fairly unambiguous indication that the monetary tightening episode was over, unless inflation took a marked turn for the worse. It is well to bear in mind here that the CBI’s own inflation forecast, published concurrent with the August interest rate decision, provided for an inflation rate of nearly 6% through the year-end. 

Tight stance transmitted to the real economy …

The most recent statistics support the MPC’s assessment from August, that the slack in the economy was growing. The labour market shows increasing signs of a slack, private consumption has lost momentum, and a range of indicators imply more modest activity than before. Households’ payment card turnover has been more muted than in recent years, lending growth has slowed, and tension in the housing market has eased. Furthermore, GDP growth in 2026-2028 looks set to be more modest than in the aftermath of the pandemic, as is discussed in our newly published macroeconomic forecast. According to that forecast, the outlook is for tepid growth in consumption, a temporary contraction in investment, and elevated unemployment in the quarters ahead.

In our opinion, the monetary stance has been transmitted effectively to the real economy. What is still lacking is the latter stage in the transmission process: from slower economic activity to declining inflation and inflation expectations. Hopefully, this will improve in the near future.

… but not yet to the inflation outlook

Inflation has proven far more persistent than expected and hoped in 2026. Higher prices for housing, imported goods, and various services items have kept headline inflation well above the CBI’s inflation target. The short-term outlook has worsened somewhat, and inflation is likely to remain high in the coming term.

In our assessment, however, the MPC will pay more attention to where inflation is headed in the years to come than to short-term swings in specific measurements. In our new macroeconomic forecast, we project that inflation will ease gradually over the forecast horizon, supported by continued monetary restraint, slower growth in domestic demand, and declining real house prices in the near future. Although the process will take more time than previously assumed, we nevertheless expect inflation to follow a downward path over the longer term.

Long-term inflation expectations have been relatively stable recently, in spite of a worsening short-term inflation outlook. Households’, businesses’, and market agents’ long-term expectations are still considerably above the CBI’s target but, in general, have not risen despite the worsening inflation outlook for the quarters just ahead. The same can be said about the breakeven inflation rate in the bond market, which has held quite stable in recent months. Although expectations still have much ground to cover before they realign with the inflation target, there are few signs that the credibility of the target itself is declining further, although persistently high inflation expectations certainly give cause for concern.

Real rates are still high

Real interest rates are still high. In terms of both past inflation and inflation expectations, the real policy rate is close to its highest in quite some time. The same is true of long-term real bond market rates. This suggests that monetary policy remains quite restrictive and that its impact on demand and inflation has yet to come fully to the fore in the next few quarters. We expect the MPC to take the view that the current interest rate level is high enough to support disinflation and that further rate hikes will not be needed.

Unwinding phase to start in spring 2027

After an uninterrupted unwinding phase lasting from autumn 2024 through year-end 2025, the CBI was forced to reverse course and start tightening interest rates again in March 2026. It has raised the policy rate by 0.75 percentage points year-to-date, to the current 8.0%.

The tone in the Monetary Policy Committee’s (MPC) statement was considerably milder in August than earlier in the year, suggesting that the tightening phase was at an end in spite of the bleak short-term inflation outlook.

We do not expect further policy rate hikes unless inflation pushes even higher than we have projected in the quarters to come. The policy rate will probably be held unchanged until next spring, whereupon the MPC could start on a gradual easing phase lasting until well into 2028. This unwinding could end with a policy rate around 6.0% by H1/2028, provided that economic and inflation developments are in line with our forecasts.

Long-term interest rates are still high and have inched upwards in 2026 to date. Based on Treasury yield curves, nominal ten-year base rates are now around 7.1%, and the corresponding real rate on indexed bonds is 3.0%. Iceland’s real interest rate is still quite high by nearly all measures.

We estimate that long-term nominal rates could fall to 6.0% and real rates to 2.5% over the forecast horizon. Accordingly, the long-term breakeven inflation rate would be 3.5%, as compared with the current rate of just under 4.0%. It should be noted, however, that long-term inflation expectations in the market are probably lower than this, as the breakeven rate includes an uncertainty premium.

On the other hand, we believe the equilibrium real interest rate in the economy to be higher than was generally thought in the not-too-distant past. This is in line with developments internationally, but it is also a sign of more persistent inflation and more resilience in the economy than was previously envisioned. We therefore consider the aforementioned forecast for 2028 to be close to equilibrium.

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