At its August interest rate decision, the MPC voted unanimously to keep the policy rate unchanged at 7.5%, thereby bringing to an end the easing phase that had started in October 2024 and delivered rate cuts totalling 1.75 from then until spring 2025.

The MPC’s forward guidance from August was quite explicit, and its statement from that meeting read as follows (our boldface):

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 2½% target.

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

Directly linking the forward guidance and the headline inflation rate strikes us as rather a double-edged sword. As we know well from our economic history – of which the recent collapse of airline Play is a timely reminder – a small open economy like Iceland can be hit by any number of shocks that suddenly change the need for a tight monetary stance. In addition, the wording above does not emphasise developments in inflation expectations as strongly as would be desirable in monetary policy guidance, although the Committee will naturally keep an eye on them, as it generally does. Nevertheless, the writing is on the wall: the MPC is of the opinion that the prerequisite for policy rate cuts is a slowdown in twelve-month inflation. Because such a slowdown is not on the horizon for the remainder of this year – not according to our forecast, and not according to the CBI’s – the MPC would have to abandon this stance in order to lower interest rates in the near future.

Play’s decision to close up shop at the beginning of this week will surely be a topic for discussion when the MPC meets next week. As we see it, though, while the company’s failure will incontrovertibly have a negative impact on economic activity in coming quarters, it will not change the economic outlook so radically that it alone will be a decisive factor in the forthcoming interest rate decision.

New business cycle with subdued growth after a contraction

Statistics Iceland’s (SI) national accounts figures have been fluctuating markedly in the recent past, and revisions of previous figures have been unusually large, and recently published GDP numbers should therefore be interpreted with considerable caution, as we have discussed recently. These recent numbers indicate that GDP contracted year-on-year in five of the last eight quarters.

Yet the economy is far sturdier than the GDP figures alone would indicate. Households’ balance sheets are generally strong, unemployment is modest, firms’ profitability appears broadly acceptable, and there are few signs of increased arrears or financial distress.

But there is no doubt that the economy is cooling. For instance, population growth has slowed markedly, job growth appears to have stalled for the present, and tensions in the housing market have eased.

ÍSB Research has recently published its new macroeconomic forecast. According to that forecast, even though SI’s preliminary figures indicate that GDP growth was all but flat in H1/2025, we expect it to measure 2.2% for 2025 as a whole. Growth will be driven equally by private consumption and investment but dampened by a negative contribution from net trade, as in 2024, when real GDP shrank by 1.0%.

GDP growth looks set to ease to 1.7% in 2026, mainly because of a contraction in investment, although export growth will gather pace. For 2027, we expect output growth of 2.4%, with investment picking up again and exports and private consumption largely holding their ground.

Our forecast provides for weaker output growth than is depicted in the CBI’s August forecast, published in the last Monetary Bulletin. Both forecasts project relatively favourable developments in the period ahead, however, with a reasonably well balanced economy and no significant slack, unemployment spike, or punishing financial headwinds for households and businesses. If MPC members share this opinion, they will probably not see a rapidly deteriorating economic outlook that warrants a major easing of the monetary stance in the near future.

No news from the inflation front?

As expected, inflation has been intransigent recently, and it seems that the final push to the inflation target will be something of a struggle. Thus far in 2025, inflation has been pirouetting around the 4% upper tolerance limit of the CBI’s target.

In the August Monetary Bulletin, the bank projected Q3 inflation at 4.2%. While the Q3 figures proved somewhat more benign at 4.0%, the outlook is for it to stay close to the 4% upper tolerance limit for most or all of this winter and then start to ease next spring. We do think the last lap in the race to the 2.5% inflation target could be a slog, though, and we do not expect inflation to reach the target during the forecast horizon. Wage developments align poorly with the target, and households and businesses appear relatively strong overall, despite persistent inflation and high interest rates.

In 2026 we expect inflation to subside a little from the current level. Our forecast assumes that it will average 3.9% in 2026 and 3.7% in 2027.

The presence of uncertainties at home and abroad need hardly be mentioned. If the economic outlook deteriorates significantly, inflation could fall more rapidly than is forecast here. On the other hand, if the ISK depreciates markedly or the housing market takes off again, it could prove even more persistent.

Inflation expectations still too high

Inflation expectations have been a burr in the CBI’s saddle. Unlike the situation in other countries, long-term inflation expectations in Iceland became unmoored from the target when inflation started surging earlier in the decade. These weakly anchored inflation expectations are a key reason Iceland’s policy rate is still far higher and inflation itself more persistent than in most neighbouring countries. This accords with international experience of central banks’ uneven success in banishing inflation in the recent term, as monetary authorities in countries with an erratic inflation history have been forced to pursue a tighter stance in order to bring inflation under control.

Just as inflation has clung mulishly to the 4% tolerance limit all year, little progress has been made in lowering long-term inflation expectations. It is mainly market inflation expectations that have moved in a promising direction. Based on the CBI’s most recent survey, market agents’ inflation expectations measured 3%, both five and ten years ahead. In Q1/2025, however, they were 3.4% for both horizons, according to the median response.

On the other hand, households’ and businesses’ five-year expectations have been unchanged at 4% and 3.5%, respectively, in all three measurements taken this year. The MPC lowered the policy rate by 1 percentage point over that period, and given how far long-term expectations are from target – at least, by most measures – it begs the question whether the Committee perhaps unwound interest rates too quickly.

Policy rate cuts hibernating for the winter

In August, the MPC held the policy rate unchanged and signalled that additional rate cuts could be expected only if inflation fell further. Based on our inflation forecast and that of the CBI itself, no additional rate cuts are on the horizon for 2025.

It is possible, though, that the CBI might relax its disinflation requirement if clearer signs of a cooling economy and reduced inflation expectations come to the fore, thereby warranting a lower real interest rate. We think it likely that the CBI will start unwinding interest rates again in spring 2026 and will keep easing them cautiously until the beginning of 2027.

That said, if inflation does not fall more than we have forecast, and if a sizeable slack does not develop in the economy, there are limits to how much the policy rate will fall. Based on the current outlook, the unwinding phase will probably conclude when the policy rate hits 5.5-6.0%.