The MPC amended its forward guidance this time by adding a clause specifying that it would use CBI purchases of Treasury bonds together with other policy instruments in order to ensure that the more accommodative monetary stance is transmitted normally to households and businesses. We consider this change a move in the right direction, as uncertainty about whether, and to what extent, such purchases would be made has affected bond market rates in recent weeks. At the press conference following the announcement, however, it was made relatively clear that the MPC expects today’s rate cut to benefits businesses more than households, as businesses rely more heavily on short-term financing than households do. It was also pointed out that households’ position was generally robust and that the buoyant housing market showed there was no need for targeted support there.

In our opinion, the tone taken this morning enhances the likelihood of a further rate cut during the coming winter, particularly if inflation turns out lower than currently projected, or if the short-term economic outlook darkens even more.

CBI expects a harsher economic winter than before

The CBI’s new macroeconomic forecast is considerably more downbeat than its predecessor, published in August. The third wave of the pandemic is the main driver of the downward revision, together with its impact on near-term economic developments both in Iceland and globally. GDP is now projected to contract by 8.5% this year, as opposed to the 7.1% contraction forecast in August. The difference stems from a larger contraction in investment and exports than in the prior forecast. Furthermore, the CBI now forecasts that the recovery in 2021 will be weaker, with GDP growth measuring 2.3% instead of the previously forecast 3.4%. But growth is now expected to be stronger in 2022, or 5.7% instead of the 3.4% projected in August.

The inflation outlook has also worsened noticeably between forecasts. Inflation is now forecast to average 2.9% in 2021, and not 2.4%, as in the previous forecast. On the other hand, it is expected to taper off quite quickly in 2021 and measure just below the CBI’s inflation target in 2022. The CBI expects unemployment to be high in the coming term, averaging 8.6% in 2021 and 6.7% in 2022. However, the bank is still optimistic about external trade, and it forecasts that the current account will remain in surplus throughout the Corona Crisis. If this materialises, it will be exceedingly welcome news and an important boost for the domestic economy. Fortunately, recent developments make such a turn of events more likely, in our view.

A misunderstood Central Bank?

At today’s press conference, Governor Ásgeir Jónsson devoted considerable time to discussing what he termed a general misunderstanding in the discourse on the bank’s conduct of monetary policy in recent months. He pointed out that Iceland had a positive policy rate and a significant inflation rate, unlike most of its peer countries. Quantitative easing and forward guidance constituted a method used by central banks when policy rates were down to zero. This is rather newsworthy, given that the CBI itself has repeatedly stressed the importance of forward guidance in monetary policy and has used QE recently despite positive interest rates. Of course, it is challenging to provide clear monetary policy guidelines when conditions on the ground are changing as fast as they are and uncertainty is this pronounced. But we think such a message could be expressed far more explicitly than has been done in the MPC’s recent statements without tying the Committee’s hands behind its back.

To put it succinctly, the CBI’s ultimate task must always be to communicate about monetary policy in such a way as to avoid widespread misunderstandings about how it is conducted. If the market lacks understanding and harbours inaccurate expectations about where the CBI is headed, the best solution is probably to sharpen the messaging about how the bank intends to apply its policy instruments. But this was somewhat lacking today, as it has been before, and the reactions from the market show it. For example, short-term bond yields have fallen markedly as of this writing, while long-term yields are broadly unchanged.

Increased bond purchases likely in the coming term

Ásgeir mentioned that it was relatively meaningless to apply QE measures concurrent with foreign exchange market intervention. On this point, we consider it useful to remember that intervening in an FX market as shallow as Iceland’s – which is subject to sizeable but temporary FX outflows – has an immediate impact, whereas the impact of increasing the money supply is more complex and depends on factors such as money velocity. As a result, the latter probably comes to the fore later than the direct impact of FX intervention does, which makes it difficult to see why the two should be considered mutually exclusive under the current circumstances.

When asked why the QE programme had been announced this spring, when the policy rate was considerably higher than it is now, the Governor answered that the objective of the announcement was to affect expectations. QE itself, however, must be applied in a conditions-based way; for example, the ISK depreciation in the autumn prompted the CBI to abandon plans submit bids in the bond market.

According to Ásgeir, the MPC thinks the bond purchase programme should shift into a higher gear in the near future. In this context, the CBI has bought Treasury bonds for at least ISK 1.5bn since 9 November, indicating that it has already begun the process. Furthermore, the MPC will respond if it notices imbalances in the bond market. The ISK is presumed to have bottomed out by now, giving greater scope for action.

Lowest or highest real rate?

The CBI’s Chief Economist, Þórarinn G. Pétursson, said when asked that Iceland’s real rate was around -3%, making it by far the lowest in the West. But it is worth noting that Þórarinn must have been referring to the CBI’s policy rate in terms of current inflation or the short-term inflation outlook. In terms of indexed Treasury bonds, Iceland’s long-term real rate is currently 0.4%, and in terms of the spread between nominal Treasury bonds and long-term inflation expectations it is in the same neighbourhood. It is hard to find rates this high elsewhere in the West. Iceland’s real rate therefore differs widely in international comparison, depending on whether it is examined in a short-term or a long-term context.

Þórarinn also noted that the equilibrium real rate would probably be lower in the near future than it has been hitherto. He mentioned that potential output would probably increase by about 1% in coming years, as opposed to an average of 2.7% in recent decades. We agree that the days of a high equilibrium real rate in Iceland are probably numbered, unless the saving rate falls markedly and/or potential output gets a massive jump-start.