The highlights from the MPC statement are as follows: 

• Inflation has risen still further since the summer, as was expected. It now measures 5.9%, its highest in two years. 
• The increase in headline inflation is driven mainly by the war in the Middle East and hikes in public levies. 
• Underlying inflation, however, has held relatively stable for some time, at just over 4%. 
• Although economic activity has clearly begun to slow, both measured and underlying inflation are still too high, as are inflation expectations. 
• Nevertheless, most indicators suggest that inflation will fall fairly rapidly in 2027, although there is considerable uncertainty, especially as regards developments in the global economy and the domestic labour market. 

Clear connection between wages and inflation in the past decade

Today’s interest rate decision was not accompanied by a new issue of Monetary Bulletin with a macroeconomic forecast. On the other hand, Thórarinn G. Pétursson, Deputy Governor for Monetary Policy, reviewed several economic factors that the MPC took into account in its deliberations. We found this a useful feature of the meeting, not least because of the currently delicate labour market situation.

Among other points, Thórarinn discussed the comparison of nominal and real wages in Iceland and the other Nordic countries, which the CBI has taken into consideration in the past. That comparison reveals a striking difference, with wages growing far more rapidly in Iceland than in the other countries, irrespective of whether or not adjustments are made for price developments. More specifically, wages in Iceland had quadrupled over the past two decades, while in the other Nordic countries they had doubled, on average. Real wages followed a similar pattern, rising far more in Iceland than elsewhere in the Nordic region. Thórarinn also showed some sample findings from an unpublished study of the relationship between wages and inflation, which shows that the statistically significant and strongly causative relationship between wage developments and inflation has been much more pronounced in the past decade than in the period beforehand. In particular, the study shows that pay rises have a strong impact on the price level during periods of high inflation. 

The Governor picked up on this message when the discussion turned to what can be called “indirect indexation”, which refers to the widespread practice in Iceland of raising prices and levies all but automatically to adjust for past inflation. He noted as well that the idea that wages should always keep pace with the price level cannot be considered a default position in Iceland any more than it is in other economies. 

The Deputy Governor also pointed out that in spite of everything, underlying inflation does not appear to be rising; indeed, by some measures it has begun to ease. He warned against overinterpreting those figures, however. 

The Governors welcomed the recent news that the Icelandic Federation of Labour and the Confederation of Icelandic Employers had agreed to extend the current wage contracts through end-2027, with minor amendments; and that the Government and companies in retail trade and related sectors had taken action to keep price increases in check. 

CBI officials were less enthused about the new bill of legislation capping rent price increases, which they considered likely to reduce the rental housing supply and to have other adverse effects in the long run, as various studies of the impact of such legislation have shown. 

Policy rate to remain flat until next spring? 

The forward guidance in the MPC’s statement takes a fairly light touch, as it did in August. It reads as follows: 

In view of this uncertainty and the persistence of inflation and inflation expectations, the MPC considers it appropriate to maintain a tight monetary stance. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations. 

For the sake of comparison, the August statement is as follows: 

In light of high inflation and inflation expectations, the MPC considers it appropriate to raise interest rates to ensure sufficient monetary restraint. Monetary policy formulation will be determined, as before, by developments in economic activity, inflation, and inflation expectations. 

In our opinion, the Committee’s forward guidance indicates quite strongly that interest rates will not be raised in November unless the inflation outlook worsens materially and inflation expectations rise. To recap, the CBI projected in August that inflation would measure 5.6% in Q3/2026 and 5.7% in Q4. Thus, in determining its next moves, the MPC is looking more closely at whether – and how quickly – inflation falls in the first few months of 2027. In its August forecast, the CBI projected that inflation would tumble in 2027, from 4.5% in Q1 to 3.0% by Q4. We agree with the bank about where inflation is heading next year, but we are more pessimistic about the speed of the decline. We expect headline inflation to measure around 4% as 2027 comes to a close. 

Thus the policy rate forecast from our recent macroeconomic forecast is still fully valid after today’s interest rate decision. We expect the MPC to hold the policy rate steady through this winter and embark in May 2027 on an unwinding phase that will end in mid-2028, when the bank’s key interest rate reaches about 6%.