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Policy rate hits five-year high

The Central Bank (CBI) announced yesterday that the policy rate would be raised by 1 percentage point, pushing key interest rate – the rate on seven-day term deposits – up to 4.75%.

The Central Bank (CBI) announced yesterday that the policy rate would be raised by 1 percentage point, pushing key interest rate – the rate on seven-day term deposits – up to 4.75%, its highest since June 2017. In all, the policy rate has been raised by 4% since the monetary tightening phase began in May 2021. This rate hike is larger than the 0.75 percentage points we had projected.

In its statement explaining the rationale for the rate hike, the CBI’s Monetary Policy Committee (MPC) noted that GDP growth has been somewhat stronger than anticipated, and domestic economic activity likewise robust. Yet “households’ and businesses’ expectations concerning the economic outlook have grown more tepid, and the global economic outlook is highly uncertain”, according to the MPC statement.

The forward guidance from the MPC is very similar to that from May, with a relatively stern tone. 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.”

GDP growth outlook relatively favourable, but inflation outlook is bleak

As we mentioned in our policy rate forecast, published last week, the Icelandic economy is running at a good clip after the COVID-19 pandemic. In Q1/2022, GDP grew in real terms by 8.6% year-on-year, according to preliminary figures from Statistics Iceland (SI). Domestic consumption is in high gear, according to payment card turnover data, and unemployment has fallen rapidly. The global outlook is quite uncertain, however, as is indicated by surveys of households’ and businesses’ expectations.

The inflation outlook has deteriorated even further since the MPC met in May. The CBI’s May forecast assumes that inflation will peak at around 8% in Q3, but it is reasonably clear that it will rise a bit higher than that. It measured 7.6% in May and looks set to rise markedly in June. The MPC also pays close attention to inflation expectations, which have worsened by all measures. A newly conducted survey among Iceland’s largest firms shows that all measures of inflation expectations have risen. The MPC appears to be very concerned about this, as it gives close consideration to long-term inflation expectations.

Households very well positioned

When asked about households’ situation, Governor Ásgeir Jónsson and Deputy Governor Rannveig Sigurðardóttir said households were very well positioned at present. They are doing well, and apparently the MPC is not worried that this steep rate hike will be too big a bite for some to swallow. The Committee considers it more important to respond with such rate hikes because inflation is obviously burdensome for households.

What’s next?

The rationale described here prompted the MPC to raise the policy rate by 1% this morning, making for a combined 4% rate increase since May 2021, when the monetary tightening phase started. Even so, the real policy rate is still negative, and presumably the MPC will want to push it into positive territory.

In our opinion, significant rate hikes can be expected over the remainder of the year. There are three more rate-setting meetings before the year-end, and the policy rate will probably be about the same as in 2016 by then – over 5% – if developments continue in the current vein. All of this depends, of course, on how successfully inflation and inflation expectations can be brought to heel.


Bergthora Baldursdottir