The CBI announced this morning that the Monetary Policy Committee (MPC) had decided to raise the bank’s policy rate by 1.0 percentage point. The key interest rate – the rate on seven-day term deposits – is now 3.75%, its highest since Q3/2019. The rate increase was larger than we had expected, and at the upper bound of published forecasts, which provided for rate hikes ranging between 0.5% and 1.0%. The policy rate has now been raised by 3.0 percentage points in five increments since May 2021, when the tightening phase began.
Sharp increase in policy rate, with more in the pipeline
A worsening inflation outlook and rising inflation expectations were the chief reasons for the Central Bank’s (CBI) 1.0 percentage point policy rate hike, announced on Wednesday. The CBI is calling for a unified response in controlling inflation so as to obviate the need for excessive rate hikes. The outlook is for hefty policy rate increases this year.
According to the MPC statement explaining the rationale behind the decision, the economic outlook has deteriorated because of the war in Ukraine. Conversely, though, there are signs of robust activity in the domestic economy. The slack in the economy has apparently closed, and tensions are developing in the labour market. Furthermore, price increases are broad-based, as can be seen in the rapid rise in underlying inflation, which currently measures 5%. Moreover, the inflation outlook has deteriorated markedly, and inflation expectations have risen by all measures.
In addition, the forward guidance in this morning’s statement takes a far sterner tone than its immediate predecessors. It reads as follows:
The MPC considers it likely that the monetary stance will have to be tightened even further in coming months so as to ensure that inflation eases back to target within an acceptable time frame. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of how high interest rates must rise.
GDP growth outlook slightly weaker for 2022
The CBI has issued a new macroeconomic forecast in Monetary Bulletin, published alongside today’s interest rate decision. The bank projects GDP growth at slightly below the February forecast, partly because of the war in Ukraine, which is adversely affecting economic activity all over the world. It has lowered its year-2022 GDP growth forecast from 4.8% to 4.6%, followed by stronger growth in 2023 – or 2.6%, as opposed to the February forecast of 2.1% – and no change from the February forecast in 2024 (2.5%). It can therefore be said that on the whole, the output growth outlook for the next three years has improved relative to the last forecast, but in this context it should be borne in mind that according to revised figures from Statistics Iceland (SI), the 2020 contraction was deeper than previously estimated.
The CBI also projects that unemployment will fall faster than previously assumed, averaging 4.5% in 2022 instead of the 4.9% provided for in the February forecast. According to Monetary Bulletin, unemployment has already fallen more rapidly than previously projected, and labour demand has been strong recently, with nearly 40% of executives from Iceland’s largest firms reporting plans to add on staff in the next six months. Unemployment is forecast to measure 3.6% at the end of the forecast horizon.
In the recent past, we have argued that the CBI’s unemployment forecasts are overly pessimistic, but this one we consider quite plausible; indeed, it is close to our own forecast from January 2022.
Inflation outlook markedly gloomier
Even though the CBI’s GDP growth forecast for 2022 is broadly unchanged, the bank considers the inflation outlook to have worsened substantially. The bank now expects far higher inflation than it did in February. Its forecasted 2022 average has risen from 5.3% to 7.4%, as the CBI expects inflation to keep rising, peaking in Q3. For 2023, it expects inflation to average 5.0%, followed by 2.9% in 2024. The upward revision of the inflation forecast is due to two factors: imported inflation driven by the Ukraine war, and domestic house price inflation, which has proven unexpectedly difficult to dislodge.
Real estate market under the microscope
The MPC statement notes, among other things, that it is “assumed that the combination of interest rate hikes and tighter borrower-based measures will slow down house price inflation and domestic demand.” When queried about this at today’s press conference, Governor Ásgeir Jónsson said that CBI officials had been surprised at how little impact the aforementioned borrower-based measures had made on the housing market. The measures applied to date involve a cap on loan-to-value (LTV) ratios and a cap on debt service-to-income (DSTI) ratios. Deputy Governor Rannveig Sigurðardóttir added that there was limited experience of such measures under circumstances like those currently prevailing, but that signs were emerging that the LTV cap was starting to bite. CBI officials also mentioned that the bank’s Financial Stability Committee, which is in charge of such macroprudential measures, was planning to meet in early June. They stressed that the CBI has all of the tools it needs to bring the market under control, and the outlook is that the real estate market will flip from catalysing inflation to deterring it in the coming term.
Plea for unified action to control inflation
The MPC takes account of the fact that in addition to actions by the CBI, decisions taken by corporations, the labour market, and fiscal authorities will play a major role in how inflation develops – and thereafter, how high the policy rate must rise. At today’s press conference, it emerged that the central bankers would like to see more fiscal consolidation in the coming term. They would also like to see discourse about the labour market centre on boosting purchasing power rather than nominal wages. This would strongly affect long-term inflation expectations. Furthermore, it was important that price-setters avoid using higher inflation as an excuse to raise prices more than is warranted, but consider instead how much they must raise prices to absorb cost increases. By the same token, in crafting discretionary measures aimed at cushioning households against higher inflation, the Government should ensure that the measures are designed to benefit those with the greatest financial need rather than targeting all consumers equally. The CBI therefore stresses that all those who can affect inflation should join together in fighting it, and we agree wholeheartedly.
Further rate hikes in the offing
As is mentioned above, the MPC considers it likely that more monetary tightening will be needed in coming months in order to bring inflation back to target in the medium term. It emerged at today’s press conference that, according to the CBI’s estimate, the equilibrium real policy rate is still just over 1%. The real policy rate, however, is still negative, which means that policy is still stimulating the economy in spite of today’s nominal rate hike.
Clearly, we had underestimated the MPC’s willingness to tighten monetary policy in a bid to exorcise inflation in the quarters to come. In our opinion, significant rate hikes can be expected over the remainder of the year. The MPC will probably implement the next rate hike as soon as late June and then continue in the same vein in the second half of the year. Consequently, the outlook is for a policy rate of at least 4.5% by the year-end, with the uncertainty profile for this preliminary forecast tilted primarily to the upside.