At its last rate-setting meeting, the MPC lowered the policy rate by 0.25 percentage points after a six-month pause in the unwinding process that began in autumn 2024. That rate cut took many by surprise, as inflation had risen during the autumn, and the Committee’s previous forward guidance had stated unequivocally that additional rate cuts would be contingent on a decline in inflation.

As grounds for the decision, the MPC cited the improved inflation outlook and bleaker economic prospects assumed in the CBI’s macroeconomic forecast, published concurrent with the decision. The Committee also noted that the mortgage market turmoil resulting from the court judgment in the so-called interest rate case, which centred on a specific segment of non-indexed floating-rate mortgages, would probably tighten households’ borrowing terms and financial conditions, all else being equal.

In its forward guidance from November, the MPC stated that further policy rate cuts would depend on the emergence of clear evidence that inflation was falling back to the target.

At the press conference following the November interest rate announcement, CBI officials also stressed that the rate cut should not be construed as a sign that the monetary easing phase was resuming after being suspended for six months. For example, Thórarinn G Pétursson, Deputy Governor for Monetary Policy, emphasised that for his part, the rate cut was primarily an attempt to offset the aforementioned changes in the mortgage market and prevent them from tightening the monetary stance vis-à-vis households.

In recent weeks, neither the short-term inflation outlook nor inflation expectations have developed as the CBI would probably have preferred. The breakeven inflation rate in the bond market has risen since the start of December, and long-term inflation expectations are still out of sync with the target. At the same time, there are obvious signs of a significant cooling of the economy.

Slack in the economy set to widen in coming quarters

In its newly published macroeconomic forecast, Íslandsbanki Research reviews the economic outlook through 2028. The outlook is for very sluggish GDP growth in 2026, and for two main reasons:

• Setbacks in various export sectors
• The impact of these setbacks and high real interest rates on domestic demand, not least investment, which will probably contract somewhat this year.

We project GDP growth at 0.6% in 2026, but the margin for error is slim, and it would take little to push the growth rate below zero. In the two years ahead, growth will pick up again as exports recover and interest rates ease. We project GDP growth at 2.8% in 2027 and 3.0% in 2028. Growth in exports will be accompanied by an upturn in investment and stronger private consumption growth than in 2026.

As is noted above, very little would be needed to tip 2026 GDP growth from positive to negative territory. For instance, if tourism shrinks significantly or if geopolitical unrest escalates, the contraction in exports could prove more severe than we have projected.

Furthermore, the outlook is for unemployment to keep rising this year, to an average of 4.5%, as opposed to 3.9% in 2025. The downturn in labour demand in H1 is due primarily to changes in the export sector and a cooler economy. But the Icelandic labour market is well known for its flexibility, and the outlook is for unemployment to subside again in H2/2026. We project that the jobless rate will average 3.8% in 2027 and approach its equilibrium level of 3.5% in 2028.

In comparison, it is worth noting that in the last issue of Monetary Bulletin, the CBI forecast GDP growth at 1.6% in 2026 and 2.6% in 2027. The bank also projected that unemployment would rise from last year’s 4.1% to 4.6% in 2026, but the CBI forecasts unemployment based on the Statistics Iceland (SI) labour force survey, which is not entirely comparable to registered unemployment according to the Directorate of Labour, the metric we use for our forecasts.

The CBI will publish a new macroeconomic forecast in Monetary Bulletin next week, concurrent with the February interest rate decision. We think it likely that the year-2026 GDP growth assumptions in that forecast will be revised downwards relative to the November forecast. But against a backdrop of unfavourable inflation movements and stubbornly high inflation expectations, such considerations will carry relatively little weight, as controlling inflation takes priority under the Central Bank Act.

Inflation a burr under the CBI’s saddle

There is no denying that inflation has been quite volatile since the CBI’s last interest rate decision date. It plunged to a five-year low of 3.7% in November, only to reverse course in December and then surge to 5.2% in January. Inflation is now at its highest since autumn 2024, just before the CBI began unwinding the policy rate.

Yesterday we released a discussion of the newest inflation measurements, which exceeded all published forecasts. In that discussion, we projected that inflation would remain above the 4% upper deviation threshold for a while yet but would ultimately start easing as summer approaches. In our macroeconomic forecast, we assume that inflation will average 4.0% in 2026 and 3.6% in 2027 but will not fall back to the target by the time the forecast horizon ends in 2028. In comparison, the CBI projected in the last Monetary Bulletin that inflation would average 4.2% in Q1/2026 and 3.4% in 2026 as a whole.

Inflation expectations have not eased since the last policy rate decision, either; on the contrary, by some measures they have risen, particularly short-term expectations. As the chart indicates, inflation expectations are far above the CBI’s inflation target by all measures, as they generally have been since mid-2022. The MPC will doubtless be seriously concerned that expectations should prove so sticky despite clear signs of both a growing slack in the economy and a decline in headline inflation from autumn 2023 until late last winter.

Policy rate cut this spring? Will they or won’t they?

The January inflation figures make it quite clear that there is no scope for a policy rate cut in Q1/2026. Presumably, the MPC will (or at least should) deliver a far sterner message than it did in November. In recent quarters, the MPC has signalled that it was primarily a question of when, not whether, the policy rate would be lowered further. At this point, it strikes us as entirely warranted to reiterate that the next change in the policy is not guaranteed to be a reduction.

We forecast that the CBI will keep the policy rate steady until inflation starts to fall again. And despite the ruminations above, we think it will probably start unwinding interest rates again in spring 2026 and will keep easing them cautiously until mid-2027. On the other hand, the question of whether the MPC sees fit to lower rates before mid-year has been cast into greater doubt by the January inflation figures. It is therefore a distinct possibility that the unwinding phase will be put on ice until after mid-year.

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. Given the current outlook, the unwinding phase will probably conclude when the policy rate hits 5.5-6.0%.

Long-term interest rates remain high despite last year’s decline in nominal rates. Based on Treasury yield curves, nominal ten-year base rates are now around 6.6%, and the corresponding rate on indexed bonds is 2.7%. Iceland’s real interest rate therefore remains quite high by nearly all measures.

We estimate that long-term nominal rates could fall to 5.9% and real rates to 2.5% over the forecast horizon. Accordingly, the long-term breakeven inflation rate would be 3.4%, as compared with the current level of just over 3.8%. 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 are convinced that the equilibrium real interest rate will be higher in the near future than was generally expected in the recent past, and that the above-described forecasts for 2028 are probably not far from the equilibrium rate.

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This report is compiled by Islandsbanki Research of  Islandsbanki hf.

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