The highlights from the MPC statement are as follows:

• Inflation fell slightly between months and measured 7.9% in October.
• Underlying inflation has subsided as well.
• Indicators continue to suggest a slowdown in private consumption and investment.
• According to the CBI’s new forecast, however, the inflation outlook has deteriorated.
• The output gap has been larger than previously anticipated, and the króna has depreciated.
• Inflation expectations have also remained high, and it appears that cost increases have a stronger and more persistent impact on inflation than they did previously.

As is noted above, the MPC’s forward guidance was conservative – and more so than we would have expected under current conditions.

It reads as follows:

Although the effects of recent interest rate hikes are coming more clearly to the fore, the poorer inflation outlook suggests that it may prove necessary to tighten the monetary stance still further. In spite of this, the MPC has decided to keep the key interest rate unchanged, owing to uncertainty about the economic impact of seismic activity on the Reykjanes peninsula. As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

We interpret this paragraph as an indication that the MPC would probably have raised the policy rate in the absence of the Reykjanes-related uncertainty. Frankly, we do not see why the MPC should feel the need to take this tone, given the recent turn of events and the way the Reykjanes situation has overshadowed the conventional monetary policy decision process for the present. In our view, it would have been more appropriate to adopt a more neutral tone, as the MPC did in October, and then reassess the situation in early February. In making this assessment, we also take note of the most recent economic indicators, including the Gallup Consumer Confidence Index and payment card turnover numbers, which suggest that the downturn in domestic demand could prove more abrupt than previously thought.

It is also worth considering that by the time of the MPC’s next decision date, set for 7 February 2024, wage agreements for a fair chunk of the private sector will have recently expired; therefore, it could be useful in the negotiation process to wield both a carrot – the prospect of lower interest rates – and a stick – the risk of higher interest rates, depending on how wage negotiations turn out.

Economic outlook broadly unchanged

The updated forecast in the newest Monetary Bulletin, published in conjunction with today’s policy rate decision, is not vastly different from the CBI’s August forecast. The bank anticipates that GDP growth will be slightly stronger in 2023 as a whole, or 3.7% instead of the 3.5% it forecast in August. The main difference relative to August lies in stronger growth in the tourism industry. The GDP growth outlook is projected to change relatively little in the next two years. The growth rate will be unchanged at 2.6% in 2024 and then inch upwards in 2025, to 2.9% instead of the 2.7% forecast in August.

As can be seen in the chart above, the CBI’s forecast for 2023 is considerably more optimistic than our own. We project this year’s output growth at 2.2%, although that forecast dates from September. The main difference is that the CBI projects that imports will contract, whereas we forecast 5% growth. The GDP growth forecasts for the next two years are very similar.

Labour market pressures remain pronounced but are on the decline

The labour market is still quite tight, but the CBI is of the opinion that tensions are easing. The CBI expects unemployment to measure 3.4% this year and increase to 4.8% in 2024, alongside reduced demand pressures in the labour market through much of 2025. Based on its previous forecasts, the CBI expects unemployment to be broadly unchanged in 2023 and then rise slightly higher in 2024.

The CBI projects considerably higher unemployment in the next two years than other forecasters do, particularly for 2024. It considers this a reflection of a tighter monetary stance and declining demand for labour due to higher wage costs.

The inflation outlook has deteriorated

The near-term inflation outlook has deteriorated relative to the August forecast, owing to stronger demand pressures in the economy and a weaker ISK. The CBI updated its year-2023 forecast from 8.6% to 8.7%, but the main difference is in the 2024 outlook, as the bank has revised its inflation forecast upwards from 4.6% to 5.7%. We consider this a more realistic scenario: as the chart below indicates, we forecast average 2024 inflation at 6.1%.

Uncertainty about the short-term inflation outlook has increased markedly with the weakening of the ISK due to the seismic activity on the Reykjanes peninsula. The inflation outlook for the near term will be affected by developments in the housing market and in the wage negotiations that will kick in as existing labour market contracts start expiring in early 2024.

What lies ahead for the CBI policy rate?

We still think it likely that the MPC will hold the policy rate unchanged for a while, although a rate hike in early 2024 has become more probable. Developments in Reykjanes over the coming weeks and months will doubtless be a major factor here, but wage negotiations and their outcome will play a key role as the winter advances. As a result, a policy rate hike in early February is fairly likely if matters involving the Reykjanes peninsula develop more or less favourably.

Interest rates will then start to fall over the course of 2024, as inflation eases and demand pressures in the economy subside. That said, the likelihood has increased that such a rate hike will take not place until H2 – with the provisos that can be expected concerning a potential volcanic eruption on Reykjanes peninsula.

Today’s reactions in the securities market suggest that market agents’ interest rate expectations have inched upwards. The yield on nominal Treasury bonds has risen by 7-16 basis points, and share prices have softened somewhat.