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Policy rate unchanged … for now?

We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to hold the policy rate unchanged on 2 October, the next announcement date. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 3.50% for the present. In our opinion, though, the MPC’s monetary easing phase is not yet finished, and we expect at least one more rate cut before the year-end.

In its upcoming decision, the MPC will presumably have to decide whether to hang fire and see how inflation, public sector wage agreements, and the autumn tourist season play out, or to push the real rate down further in a bid to facilitate investment and improve the operating conditions of firms currently facing headwinds.

We assume the former of these will carry the day, although a rate cut is not inconceivable. In August, MPC members considered it important to proceed with caution during the monetary easing phase, owing to the possibility that inflationary pressures could escalate in the near future. Even so, the decision to lower the policy rate in August was unanimous, and no other option was seriously considered, if the MPC minutes are any indication of how things went. The forward guidance in the August statement was neutral, however:

Near-term monetary policy decisions will depend on the interaction between developments in economic activity, on the one hand, and inflation and inflation expectations, on the other.

As far as we can see, there have been no decisive changes in this “interaction” in the weeks since the August decision.

The economy is cooling

Revised Statistics Iceland (SI) figures for H1/2019 took many by surprise, with GDP growth for the period measuring 0.9%. The figures show clearly, though, that the economy is cooling. For instance, domestic demand contracted by 2.4%, albeit offset by an unusually favourable contribution from net trade.

Fortunately, the summer tourist season appears to have turned out stronger than many observers had feared earlier in the year. Although tourist arrivals declined by a full 17% year-on-year during the period following WOW Air’s collapse – i.e., from April through August – average spending per tourist appears to have risen significantly. The average length of stay has increased, and payment card turnover per tourist has risen sharply in ISK terms. Last year’s ISK depreciation probably helped quite a bit in this regard, together with changes in Icelandair’s focus and indications that WOW passengers spent less in Iceland than others do. How tourism will fare over the coming winter is uncertain, however, and it is difficult to say whether and when visitor numbers will begin to rise again.

According to our newly published macroeconomic forecast, the outlook for 2019 as a whole is for a 0.1% contraction in GDP. Actually, it is perhaps more accurate to say growth will be flat, as this figure is well within the margin for error of zero growth. A sharp contraction in business investment and services exports counterbalances growth in consumption and investment (excluding business investment) and a strong contraction in imports.

For 2020, we expect relatively slow growth of about 1.3%, driven by modest growth in domestic demand. We expect the economy to pick up to about 2.8% in 2021, as private consumption and exports regain momentum.

Inflation expectations modest

We have found it striking how little impact last year’s ISK depreciation ultimately had on inflation. At the end of 2018, inflation measured 3.7%, the highest in five years. It has averaged 3.1% in 2019 to date and measured 3.2% in August.

Inflation expectations have subsided as the inflation outlook has improved in recent quarters, and the breakeven inflation rate in the bond market has followed a similar pattern. Presumably, these developments indicate increased confidence that inflation will continue to fall and will be within acceptable limits in the coming term.

Lower policy rate in the pipeline

Thus far in 2019, the CBI has lowered its policy rate by 1 percentage point, citing the poorer economic outlook, the improving inflation outlook, and declining inflation expectations. The CBI’s key rate — i.e., the rate on seven-day deposits — is now 3.5%, its lowest since the inflation target was adopted in spring 2001.

Even if the MPC decides to keep the key rate unchanged in October, this need not mean the monetary easing phase is over. If our most recent inflation forecast is borne out, inflation will fall quite swiftly in coming months, to 2.4% by the year-end. This, together with clearer signs of cooling in the labour market and the economy as a whole, will presumably be decisive in prompting the MPC to lower interest rates at least one more time before the end of the year.

Thereafter, we expect the policy rate to remain steady at 3.25% through 2020 and then begin rising again in 2021 as the economic outlook improves. The uncertainty in our forecast is concentrated more on the downside, in that interest rates could fall further in the short run and remain lower throughout 2020 than we have projected, particularly if economic developments are less favourable than we anticipate.


Jón Bjarki Bentsson

Chief economist