The decision doubtless took many by surprise, as the vast majority of official forecasters, ourselves included, had projected an unchanged policy rate, as did most participants in the expectations surveys published prior to the decision date. Particularly unexpected was the degree to which the changed mortgage lending environment affected the MPC’s decision, as most observers would probably have wagered that any potential rate cut would be based primarily on the deteriorating economic outlook.

The highlights from the MPC statement are as follows:

• Headline inflation measured 4.3% in October, after rising by 0.2 percentage points from the previous month. It has remained close to 4% for nearly a year. Underlying inflation has developed in broadly the same manner.
• Growth in domestic demand has slowed in line with a tight monetary stance, and signs of a turning point in economic activity are growing ever clearer.
• According to the Bank’s newly published forecast, the positive output gap seems to have closed and GDP growth looks set to slow more than previously projected.
• This is driven largely by the series of export sector shocks and, just as importantly, the turmoil in the domestic mortgage market following the recent Supreme Court decision.
• As a result, the Bank forecasts that inflation will subside more rapidly than previously assumed. Pay rises are still sizeable, and inflation expectations continue to measure above target. Substantial uncertainty therefore remains.
• The turbulence in the mortgage market is likely to cause households’ borrowing terms and financial conditions to tighten, even though the Bank’s real interest rate has held broadly unchanged.
• In view of this, the Committee considers it appropriate to offset this tightening by lowering interest rates.

The forward guidance from the MPC is slightly changed from the October statement. It reads as follows:

However, further decisions to lower interest rates will depend on the emergence of 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.

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

Many factors have moved in the right direction, but the conditions that would enable an easing of the real interest rate have not yet emerged. Further interest rate cuts will depend on whether inflation moves closer to the Bank’s 2½% target.

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

At the press conference following today’s interest rate announcement, CBI officials stressed that the rate cut should not be construed as a sign that the monetary easing phase was resuming after being suspended for six months. For example, Thórarinn G Pétursson, Deputy Governor for Monetary Policy, emphasised that for his part, the rate cut was primarily an attempt to offset the aforementioned changes in the mortgage market and prevent them from tightening the monetary stance vis-à-vis households.

Weaker GDP growth, lower inflation?

The CBI’s new macroeconomic forecast published today in Monetary Bulletin is considerably more pessimistic than before about the economic outlook. Particularly noticeable is the bank’s downward revision of year-2025 GDP growth from 2.3% to 0.9%. The CBI estimates that GDP contracted in Q3, after tepid growth in the first half of the year. Prospects for 2026 have dimmed as well, in the bank’s opinion, owing largely to a spate of export shocks coupled with weaker private consumption growth. The CBI now projects 2026 GDP growth at 1.6% instead of the previous 2.1%, although it still expects growth to measure 2.6% in 2027. The CBI projects year-2028 GDP growth at 2.4%.

The CBI’s inflation forecast has improved slightly, and the outlook is for lower inflation in 2026 than was projected in August. The bank expects inflation to measure 4.3% in Q4/2025 and 4.2% in Q1/2026. It is more upbeat about the near-term outlook because of a more favourable initial position. The CBI’s projections are in line with our own most recent inflation forecast, whereas in August the bank was considerably more pessimistic about the near-term outlook, forecasting 4.5% inflation in Q4/2025.

The difference between our forecast and the CBI’s lies in year-2026 disinflation. The CBI now considers the long-term inflation outlook to have improved, mainly because of a larger slack in the economy. It projects average inflation at 3.4% in 2026 and 2.6% in 2027. This represents far more rapid disinflation than we projected in our most recent forecast, as can be seen in the chart above.

How credible in the CBI’s forward guidance?

Although the tone in the MPC’s forward guidance and bank officials’ subsequent statements is quite stern, we cannot avoid asking ourselves how much bite lies behind the CBI’s bark. In its messaging over the past half-year, the bank has explicitly conditioned any potential rate cut upon a decline in headline inflation. For example, the minutes from the MPC’s October meeting read as follows: “… Because of the strong correlation between inflation expectations and current inflation, the Committee considered it vital to see a clearer drop in inflation before cutting interest rates further.” (our boldface)

Although the economic outlook has indeed worsened materially and the changes in the mortgage market have tightened the monetary stance, it could be argued that the results the MPC is trying to achieve could have been elicited from an unchanged policy rate and a more accommodative message instead of a rate cut coupled with strict forward guidance. Any central bank’s forward guidance represents a balancing act between policy predictability over time and policy agility in responding to changed circumstances. Clearly, predictability was put on the back burner this time, as can be seen in the fact that no published forecasts assumed a 0.25-point rate cut, nor did market expectations surveys point strongly in that direction. {ATH: Since you don’t say outright that NO survey respondents expected a rate cut, I assume there might have been some outliers. I have tried to hedge the language to reflect this possibility.}

In our opinion, the heft of the CBI’s forward guidance is diminished as a result, and we think it just as likely that further rate cuts will follow in the quarters ahead, even if inflation does not fall decisively in coming months. Securities market reactions suggest that expectations about interest rates in the next few quarters have changed somewhat. The OMXI15 share price index is up by just over 1% as of this writing, and yields on indexed and nominal Treasury bonds alike have tapered off, most noticeably at the short end of the yield curve.

Our preliminary forecast provides for rate cuts amounting to 0.5 percentage points per quarter in 2026, bringing the policy rate to 5.5-6.0% by next autumn. At that point, further easing will depend on whether inflation moves closer to the CBI’s 2.5% inflation target in the coming term. If our forecast materialises, inflation will be too persistent to provide scope for larger rate cuts in the near future. It could turn out that an insufficient monetary stance will ultimately cause inflation to be more persistent and interest rates higher than is desirable later on. We hope that developments prove more favourable, however.