During the run-up to the decision, opinion was also divided among forecasters, with some projecting an unchanged policy rate and others – ourselves included – predicting a 0.25-point rate hike. Furthermore, in a survey taken a week ago by Icelandic Financial News, the vast majority of respondents expected an unchanged policy rate, yet in an interesting twist, the share who considered a rate hike appropriate (31%) was far larger than the share who expected a rate hike (13%).

The highlights from the MPC statement are as follows:

Most economic indicators now suggest that economic activity has slowed.

• In spite of this, inflation has risen again and now measures 5.2% for the second month in a row.
• Underlying inflation has risen and is at its highest in over a year.
• Inflation expectations have also begun to rise.
• Steep increases in the price of oil and other commodities following the escalation of the conflict in the Persian Gulf have already led to further rises in inflation expectations in the bond market.
• If the conflict drags on, there is the risk that price increases will become more widespread, especially when inflation expectations are as high as they are at present.
• Thus there is heightened risk that the review clause in wage agreements will be triggered later this year, which could exacerbate underlying inflationary pressures even more.

The MPC’s forward guidance has changed radically since February. It now reads as follows (our boldface):

Furthermore, the Committee is prepared to tighten the monetary stance still further to ensure that inflation eases towards the target, even though this could further curtail economic activity.

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

For the sake of comparison, the February statement read as follows:

Further decisions to lower interest rates will depend on clear evidence that inflation is falling back to the Bank’s 2½% inflation target.

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

Thus the MPC’s messaging has pivoted sharply: previously it was a question of when, not whether, interest rates would be lowered further, but now it is highly likely that rates will be raised further in the near future.

Although higher interest rates generally give little cause for joy, we think it positive that the MPC should take such a decisive step this time. We hope that this will ultimately help bring inflation down sooner and that interest rates will end up lower than they would have been without such clear action.

Underlying inflationary pressures and rising inflation expectations

At the press conference following the announcement of today’s interest rate decision, CBI officials outlined the main reasons for the change in the MPC’s view of the inflation outlook and the need for a rate hike now, stressing the importance of domestic contributors to current inflation. Not least, they were concerned about how markedly wage developments in Iceland differed from those in neighbouring countries. They also reiterated that while the CBI had no control over global oil and commodity prices, they were deeply concerned about second-round effects on the general price level, wages, and inflation expectations.

Furthermore, Governor Ásgeir Jónsson and Deputy Governor Þórarinn G Pétursson noted that recent economic developments had been broadly in line with the scenario presented in Monetary Bulletin in February. They were convinced that the CBI’s interest rate stance was passing through to the real economy – i.e., domestic demand, the labour market, and the real estate market – as they had expected, but the impact of interest rates on inflation expectations and developments in inflation itself was less favourable thus far.

The bond market reacted strongly to this morning’s news. As of this writing[AB1] , inflation-indexed Government bond yields are up by 7-10 basis points, while yields on nominal bonds have either risen marginally or fallen. Real interest rates have therefore risen and the breakeven inflation rate has fallen, reflecting the initial impact that CBI presumably wants to see.

Another rate hike in May?

In view of today’s news and the shift in the CBI’s tone, we have updated our preliminary policy rate forecast for coming quarters. In view of today’s forward guidance, the desire of the MPC minority to raise the policy rate more than was actually done, and our own inflation forecast, we think another interest rate hike in May more likely than before, not less. Hopefully, and presumably, that will suffice to buttress the credibility of the inflation target[AB2] , unwind the rise in inflation expectations, and bring the real policy rate closer to where it was at the start of the year.

Interest rates could start to fall again in Q4, when – we hope – clear signs of disinflation will have emerged, uncertainty about the impact of the Persian Gulf war on inflation and economic developments has receded, and the slack in the economy has widened.