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Policy rate hike driven by bleaker inflation outlook and stronger economy

The Central Bank’s (CBI) 0.75 percentage point policy rate increase was in line with expectations. The decision was driven largely by the darkening inflation outlook juxtaposed with a relatively favourable economic outlook, with signs of a cooling housing market and a short interval between rate-setting meetings the most likely reason the rate hike was not larger than 75bp. The policy rate will probably be at least 6% at the end of the year.

The CBI announced this morning that the Monetary Policy Committee (MPC) had decided to raise the policy rate by 0.75 percentage points. The key interest rate – the rate on seven-day term deposits – is now 5.5%, its highest since August 2016. The rate increase was in line with official forecasts and at the median of market expectations.

The policy rate has now been raised by a total of 4.75 percentage points since the CBI began its monetary tightening phase in May 2021, and by 2.75 percentage points in 2022 to date.

According to the MPC statement explaining the rationale for the decision, the outlook for 2022 is for more robust GDP growth than was previously assumed, not least because of stronger private consumption and a more rapid rebound in the tourism industry. The slack in the labour market had narrowed steadily, and a larger positive output gap had developed than the CBI had forecast in May.

The inflation outlook had continued to cloud over, reflecting stronger economic activity than was forecast in May, as well as more persistent house price inflation and higher global inflation. Furthermore, inflation expectations had continued to rise by most measures.

The forward guidance in the MPC statement is unchanged since June, with the same stern tone regarding the quarters to come. It reads as follows:

The MPC considers it likely that the monetary stance will have to be tightened even further so as to ensure that inflation eases back to target within an acceptable time frame. Near-term monetary policy decisions will depend on developments in economic activity, inflation, and inflation expectations. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of how high interest rates must rise.

The economic outlook is relatively favourable …

As is noted above, the CBI now expects stronger GDP growth in 2022 than it did in its last macroeconomic forecast, issued in May. On the other hand, it also expects somewhat weaker growth in 2023 and 2024, not least because the global economic outlook has deteriorated. The CBI projects GDP growth at 5.9% in 2022, 1.9% in 2023, and 2.3% in 2024. The bank assumes, as we have, that growth will be increasingly driven by exports, and furthermore, that the contribution from consumption and investment will be much smaller in coming years than it was in 2022 – and 2021 as well, actually.

At the press conference following the publication of the interest rate decision, Governor Ásgeir Jónsson said that Iceland was in many ways in an enviable position as regards the economic outlook. The economy had picked up faster than previously feared, the employment situation was good, and growth prospects better than in many neighbouring countries. Rising interest rates were not only a response to the poorer inflation outlook; they also reflected the recovery and the rapidly closing slack in the domestic economy. He noted that expectations of a severe pandemic-driven economic contraction had not materialised and that the CBI’s growth forecasts had steadily been revised upwards in the recent term.

The CBI’s unemployment forecast had changed marginally since May, partly in response to the past few months’ faster-than-expected decline in unemployment. On the other hand, the bank now expects a somewhat higher jobless rate in coming years than it did previously. The difference is not large, however, and the outlook for the labour market remains quite good. Actually, the bigger challenge for the near term is to fill the positions that are created or become available rather than to find work for job-seekers.

… but the inflation outlook is deteriorating

The CBI’s new inflation forecast is considerably more downbeat than the last one. The bank now expects inflation to peak at nearly 11% in Q4/2022. It will then ease steadily but will be over 5% a year from now and more than 3% in two years’ time. In comparison, we have forecast that inflation will top out at approximately 10% in the next few months.

The difference between the two forecasts lies partly in differing expectations concerning near-term developments in house prices. According to the CBI’s new issue of Monetary Bulletin, the surge in house prices does not yet appear to be losing momentum, and the bank’s baseline forecast assumes that a slowdown can be expected over the course of 2023. But we think it likely that house price inflation will start losing steam in the next few months. It emerged at this morning’s press conference, however, that CBI officials consider it possible that indicators now emerging could suggest that the housing market is moving towards a better balance.

In response to questions about criticism of the monetary tightening phase, CBI officials pointed out that the purpose of the rate hikes is to exert some control over inflation, which could otherwise prove highly detrimental to households in the long run. It would be short-sighted to keep interest rates low in order to put a lid on leveraged households’ borrowing costs, only to have living standards eroded by runaway inflation. They also pointed out that real wages among the lowest-paid workers had continued to rise in spite of the contraction in average real wages. As before, CBI officials asked the Government and the social partners to join with them in fighting inflation – a message we endorse wholeheartedly.

Further rate hikes later this year

The MPC statement and the discussion at this morning’s press conference made it quite clear that the monetary tightening phase is not over yet. The Governor mentioned that the next interest rate decision date is not too far off, and this, plus the aforementioned signs of possible cooling in the housing market, may well have been why the MPC did not raise the policy rate even more this time. There are two interest rate decision dates left on the CBI’s calendar for 2022: 5 October and 23 November. We expect the policy rate to be at least 6% at the end of the year. A rate hike to 6% is probable in October, with perhaps an additional increase in November.


Jón Bjarki Bentsson

Chief economist