As the CBI announced this morning, the Monetary Policy Committee (MPC) decided to lower the bank’s policy interest rate by 0.5 percentage points, in line with expectations. The bank’s key rate – the rate on seven-day term deposits – will therefore be 8.5%, its lowest since May 2023. The decision was consistent with published forecasts, which provided unanimously for a 0.5-point rate cut. Most market agents participating in surveys conducted by Iceland Financial News, Innherji, and the CBI itself expected a 0.5-point rate cut as well.
Policy rate cut in line with expectations; further monetary easing on the horizon
The Central Bank’s (CBI) 50-bp policy rate reduction was in line with expectations. In the bank’s opinion, inflation prospects have improved and the economy looks set for a relatively soft landing. The monetary easing phase has finally begun, and the outlook is for hefty rate cuts in the quarters ahead.
The tone in today’s MPC statement can be described as consistent with the previous one: cautious, but neutral overall.
The highlights from the MPC statement are as follows:
- Inflation has eased recently, measuring 5.1% in October.
- The decline in inflation has been broad-based, and underlying inflation has fallen as well.
- Furthermore, inflation expectations have declined overall, and the real rate has therefore risen.
- The effects of a tight monetary stance can still be seen in economic activity, and growth in domestic demand has lost pace.
- Unemployment continues to inch upwards, and the outlook is for demand pressures in the economy to ease, albeit more slowly than previously assumed.
Today’s forward guidance from the MPC is slightly changed from the October statement. It reads as follows:
Persistent inflation and inflation expectations above target call for caution, however. As a result, it is still necessary to maintain an appropriately tight monetary stance in order to bring inflation back to target within an acceptable time frame.
As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.
For comparison, the forward guidance accompanying the October decision was as follows (the boldfaced text was omitted from the November statement):
Persistent inflation, inflation expectations above target, and strong domestic demand call for caution, however. As a result, it is still necessary to maintain an appropriately tight monetary stance in order to bring inflation back to target within an acceptable time frame.
As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.
We interpret the MPC’s statement to mean that the monetary easing phase has well and truly begun. The MPC wants to keep the real rate fairly high, though – at least for the next several months – and will probably take data-driven decisions rather than holding stubbornly to a predetermined rate-cutting schedule no matter what the evidence says.
It emerged at this morning’s press conference that today’s relatively terse MPC statement could be construed to mean that Committee members are broadly in agreement about the big picture concerning inflation and the economy, and therefore about the need for monetary restraint in the near future.
It took us slightly by surprise that no mention was made of the recent collapse of the Government and forthcoming elections, nor of the current and expected strikes among public sector workers, both of which represent short-term uncertainties. It came to light at the press conference that CBI officials expect the private sector wage agreements finalised earlier this year to set the tone for the labour market as a whole. In essence, then, they did not expect that consensus to dissolve, although such a turn of events could not be ruled out. Furthermore, some fiscal uncertainty was eliminated when Parliament passed the 2025 National Budget with relatively few amendments, and there were no glaring indications of an abrupt change in fiscal policy in the near future.
Declining inflation and a soft landing in the offing
The CBI’s new macroeconomic forecast, published today in Monetary Bulletin, sketches a picture of lower inflation and relatively slower GDP growth in the coming term than was provided for in its August forecast.
For instance, the CBI now projects average year-2025 inflation at 3.4%, down from 4.2% in the August forecast. It also expects inflation to fall below the 4% upper deviation threshold of the inflation target in Q2/2025 and reach the 2.5% target in mid-2026.
Furthermore, the CBI now expects GDP growth to be flat this year and not 0.5%, as it forecast in August. Offsetting all of this, however, is Statistics Iceland’s (SI) upward revision of historical GDP growth figures in the interim. The CBI now projects output growth at 1.9% in 2025 and 2.3% in 2026, down from its August forecasts of 2.0% and 2.6%, respectively. The bank is of the opinion that consumption, investment, and exports will grow steadily in coming years, although a minor setback in business investment is expected in 2025.
The MPC is of the view that broad-based disinflation, including the decline in services price inflation and the turnaround in the real estate market, will support monetary policy in the coming term. The outlook is for continued broad-based disinflation and a cooler housing market. In the new issue of Monetary Bulletin, the CBI notes that house prices are expected to rise more in 2024 than was envisioned in August, although real house prices are projected to fall slightly over the next two years.
No mention was made at today’s press conference of the interest rate differential with abroad in view of inflows into Treasury bonds. According to Monetary Bulletin, however, non-residents’ inflows for investment in Treasury bonds have increased this autumn and have contributed to the recent appreciation of the ISK. Even so, the CBI considers the foreign exchange market well balanced, but it expects a slightly higher exchange rate over the forecast horizon than it did in August.
At the press conference, it was noted that the household saving rate is high at present. This could prove to be a risk factor in coming quarters if households start using large chunks of their savings for consumption spending, thereby pushing the real interest rate downwards. On the plus side, debt-driven private consumption had been limited in the recent term and households’ financial situation was generally sound, although it varied from one group to another.
The risk that Icelandic households will suffer financial shocks should be mitigated by the fact that if the CBI’s forecast is borne out, real disposable income will rise steadily over the forecast horizon. Furthermore, unemployment is not expected to rise steeply in the near future, although the CBI does expect it to inch upwards from the recent level. In general, the CBI’s new forecast paints a picture of a relatively soft landing, adopting a tone similar to ours in our end-September macroeconomic forecast.
The monetary easing phase is out of the starting blocks
Although the CBI will presumably continue unwinding the monetary stance more or less uninterrupted in coming quarters, the MPC does not want to move too fast and will probably choose to keep the real policy rate relatively high for a while yet. At the press conference, Governor Ásgeir Jónsson emphasised that in the near future, a tight real policy stance would be needed to promote a balanced economy. Over time, however, the conditions for a more accommodative real policy stance should develop.
If inflation falls as is forecast and inflation expectations follow in its wake, we think it likely that the MPC will lower the key interest rate by 25-50 bp at each rate-setting meeting in 2025. According to the preliminary projection in our policy rate forecast from last week, the key rate will be around 6.5% at the end of 2025 and 5.5% by mid-2026. We believe this forecast is still fully valid. If economic developments fall short of expectations or the inflation outlook improves more than is currently anticipated, the MPC could lower rates at a faster pace.
