Policy rate lowered by half a percentage point, to 4.0%

The Central Bank of Iceland’s (CBI) policy interest rate is now at its lowest in seven years, after a bold rate-cutting move by the Monetary Policy Committee (MPC) this morning.


The Central Bank of Iceland’s (CBI) policy interest rate is now at its lowest in seven years, after a bold rate-cutting move by the Monetary Policy Committee (MPC) this morning. The economic outlook has deteriorated markedly, in the CBI’s opinion, while the inflation outlook has improved. Further rate cuts are likely to follow in the months to come.

This morning, the MPC announced that the CBI’s policy rate would be lowered by 0.50 percentage points in response to the changed economic and inflation outlook. The key rate — defined at present as the rate on seven-day term deposits — is now 4.00%. This is the lowest seven-day deposit rate ever set by the CBI, and the rate previously defined as the key rate has not been this low since 2012.

The MPC statement reads as follows: “Although the recently finalised private sector wage agreements provide for sizeable pay increases, the outcome was better in line with the inflation target than was widely expected. Inflation expectations have therefore moderated again after having risen markedly over the course of 2018. Market agents’ long-term inflation expectations have now eased back below 3%.”

The CBI is therefore relatively satisfied with the recent wage agreements, and reduced uncertainty about wage developments doubtless played a major role in facilitating today’s rate cut.

0.4% contraction projected for 2019

According to the CBI’s new macroeconomic forecast, output will contract by 0.4% this year instead of increasing by 1.8%, as was forecast in February. Furthermore, unemployment is projected to average 3.9% this year, up from 3.1% in the last forecast. The bank therefore considers the economic outlook for 2019 as a whole quite a bit gloomier than it did in February. The main reason for the poorer economic outlook, in the CBI’s opinion, is the substantial decline in tourist arrivals following the collapse of WOW Air, although the failure of the capelin catch, a change in the fiscal stance, and the poorer global growth outlook all pull in the same direction. The CBI projects year-2020 GDP growth at 2.5%.

The inflation outlook, however, has improved significantly, in the CBI’s opinion. The bank now projects average year-2019 inflation at 3.2%, down from 3.6% in the February forecast. The CBI also expects inflation to align with the 2.5% inflation target in mid-2020 and remain close to target thereafter.

In the CBI’s view, the economy is more resilient than before and considerably better equipped to withstand the contraction, not least because of reduced private sector debt and a stronger external position. As a result, the current headwinds are not expected to act as a long-term drag on the economy.

Further rate cuts likely this year

As before, we think it likely that the MPC will lower rates further before the end of this year. This part of the MPC statement is interesting in this respect: “Furthermore, monetary policy has considerable scope to respond to the contraction, particularly if inflation and inflation expectations remain close to the target, as is currently envisioned.”

When asked about this at today’s press conference, the Governor sounded amenable to further rate cuts, provided that short-term economic developments did not turn out substantially more favourable than currently forecast and that inflation expectations remained modest or, preferably, fell even further.

We think it likely that another rate cut — this time by 0.25 percentage points — will come next month, followed by one or two more 0.25-point reductions in the second half of the year. If our forecast materialises, the policy rate will be 3.25-3.50% by the end of the year, the lowest since the current inflation-targeting monetary policy regime was adopted in 2001.

Author


Jón Bjarki Bentsson


Chief economist

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