Yesterday morning the Central Bank (CBI) announced the Monetary Policy Committee’s (MPC) decision to keep the bank’s policy interest rate unchanged. The CBI’s key interest rate – the rate on seven-day term deposits – will therefore remain steady at 7.5%. Until now, the MPC had lowered the policy rate five times in succession, starting in October 2024, but now the rate cuts have been relegated to the pending file. The decision was in line with published forecasts, all of which assumed an unchanged policy rate. The decision was unanimous, and today’s MPC statement is virtually unchanged from its predecessor, issued in May.
Policy rate reductions on ice
The policy rate has been left unchanged for the first time in a year. The Central Bank forecasts that inflation will be quite stubborn in the coming term. ÍSB Research expects the policy rate to remain flat until well into 2026.
The highlights from today’s statement are as follows:
- Inflation measured 4% in July, after falling by 0.2 percentage points from the previous month.
- According to the CBI forecast, it will rise again in the months ahead but then start to ease in early 2026.
- Growth in domestic demand has subsided in line with a tight monetary stance. Capacity pressures in the economy have therefore eased, as can be seen in the cooling of the housing and labour markets.
- Economic activity still appears relatively robust, wages have risen markedly, and inflation expectations remain above target.
The forward guidance from the MPC is virtually unchanged since May. It reads as follows:
Although inflation has eased and inflation expectations have fallen in the recent term, inflationary pressures remain. The conditions that would enable an easing of the real interest rate have therefore not yet emerged. Further interest rate cuts will depend on whether inflation moves closer to the Bank’s 2.5% target.
As before, near-term monetary policy formulation would be determined by developments in economic activity, inflation, and inflation expectations.
Stronger growth, higher inflation
The CBI’s new macroeconomic forecast, published concurrent with the interest rate decision, is a bit more upbeat about output growth, particularly in 2025. The bank projects GDP growth at 2.3% this year (up from 1% in the May forecast), followed by 2.1% in 2026 and 2.6% in 2027. The strong upward revision of 2025 output growth is due mainly to base effects from Statistics Iceland’s (SI) revision of last year’s figures, plus an investment-driven increase in domestic demand.
The CBI’s near-term inflation forecast has deteriorated markedly relative to the May forecast. The bank projects inflation at 4.5% in Q4/2025, well above its previous forecast. As a result, inflation will be considerably higher in the first half of the forecast horizon. The CBI projects that it will average 4.2% in 2025, 3.6% in 2026, and 2.6% in 2027. This lines up well with our own most recent forecast of 4.5% inflation in Q4/2025. We are more pessimistic about medium-term developments, though, and do not expect inflation to align with the target during the forecast period.
The CBI’s inflation forecasts have grown markedly gloomier since it started lowering the policy rate last autumn. At that time, the bank assumed that inflation would measure 3.4% this year and 2.7% in 2026. Returning inflation to target within an acceptable time frame is therefore becoming an ever more elusive goal.
Policy rate likely to remain flat through the year-end
The MPC’s decision to keep interest rates unchanged came as no surprise. What drew our attention, however, was the Committee’s statement, in which it repeated its message from May all but verbatim, despite a considerably bleaker inflation outlook and a more robust economy.
When the Committee was asked whether its statement should have taken a sterner tone, given higher inflation, stubborn inflation expectations, and stronger domestic demand, the response was that in spite of everything, the real economy was headed in one direction, with clear signs of cooling. MPC officials also said that the statement was clear and that the current real policy rate had been effective and would suffice to bring inflation back to target. They stressed, however, that they would not hesitate to take whatever action was necessary to bring inflation to target, including raising interest rates again.
In our opinion, the tone in the MPC’s forward guidance could have been more admonitory. The inflation outlook has indeed clouded over, and target-level inflation is proving an ever more distant prospect. It is clear that by holding the policy rate unchanged for the first time in a year, the Committee is planning to pause and consider its next steps.
There are two more policy rate decisions on this year’s calendar, one in October and one in November. As is noted above, the MPC said outright in its statement that further policy rate cuts will depend on whether inflation moves closer to the Bank’s 2.5% target. Based on the CBI’s newest forecast, inflation is not likely to fall to any marked degree before mid-2026. We expect the policy rate to remain unchanged through the end of the year and well into next year unless the economic outlook deteriorates substantially.
