All that said, we certainly do not exclude the possibility that interest rates will be held unchanged, as it is difficult to read the interest rate tea leaves at present. In March, no MPC member even raised the possibility of increasing the policy rate, and the forward guidance from the Committee was neutral. But the winds can change abruptly, as is discussed below, and we think it more likely than not that the MPC will take this opportunity to emphasise its determination to keep inflation in check using the tools at its disposal. If no rate hike is decided this time, it can certainly be expected that the Committee will sharpen its tone and stress that it will respond to inflation, which is well above the target, as soon as economic conditions allow.

It is also likely that the rules restricting mortgage lending will be tightened concurrent with the interest rate decision, or soon thereafter. According to the current rules, which are under the aegis of the CBI’s Financial Stability Committee (FSN), mortgage lending may not exceed 85% of the market value of the underlying property. The FSN is authorised to lower that ratio and/or restrict the total amount loaned or the ratio of debt service to income. But it would be a little strange to use these tools solely to ease inflationary pressures, as their primary purpose is to safeguard financial stability. The interaction between them and higher interest rates is therefore more conducive to cooling the housing market under current circumstances.

Uncertainty about economic recovery is receding

Since the CBI’s last interest rate decision, the near-term economic outlook has brightened and uncertainty about the forthcoming recovery has waned. Vaccination against COVID-19 is proceeding apace, both in Iceland and among major trading partners. The risk of a serious setback in the pandemic is therefore diminishing steadily in Iceland. A plan to relax public health measures within Iceland and on the border in coming months has been prepared, and such plans have been put in place in many neighbouring countries. Vaccinated tourists from the US have already begun visiting Iceland in greater numbers, and news reports on bookings with airlines offering flights to Iceland and tourism companies within the country have been positive.

The return of tourism as a large export sector will bring with it both a vast increase in export revenues and a large number of jobs. We projected last January that unemployment would start to decline relatively quickly later this year, and this forecast appears likely to materialise.

Households’ and businesses’ expectations reveal growing optimism in the public sector. Payment card turnover figures show both that most households maintained their consumption spending this past winter and that consumption is starting to pick up again.

Of course, the CBI must tread lightly so as not to extinguish the economic recovery. Raising interest rates back to the level prevailing for the first eight months of the pandemic is not likely to do so, however, particularly if such a rate hike is accompanied by robust discretionary support measures for those households and businesses that have been hit hardest.

Inflation more persistent than previously hoped

Inflation proved considerably more stubborn in Q1/2021 than had been assumed in most forecasts. In April, it measured 4.6%, its highest in eight years. The April rise in the CPI was fuelled by house prices, which have risen by 10.6% nationwide in the past twelve months, according to Statistics Iceland’s housing market index. As we have discussed previously, it appears that house price inflation is driven at present by the interaction between brisk demand due to rising real wages, most households’ strong financial position, and favourable lending terms, on the one hand, and a limited supply of new residential housing, on the other.

According to the CBI’s Financial Stability 2021/1 report, published in April, the bank considered house price inflation modest at the time, and supported by fundamentals, as is discussed above. The April measurement may well have affected that assessment somewhat, however. Nevertheless, the CBI has tools other than interest rates that it can use to combat upward pressure on house prices, particularly if the risk exists that imbalances in the market will jeopardise financial stability. It is likely that the CBI will consider the interactions among these policy instruments and interest rate hikes in order to curb house price inflation. Based on the assessment in the recent Financial Stability report, however, there are probably limits on how far the bank is willing to go in tightening the mortgage lending market by imposing maximum loan-to-value ratios or restricting loan amounts or debt service ratios.

Inflationary pressures are not limited to the housing market, either, as can sometimes be heard in the general discourse. Of the 4.6% inflation figure for April, 2 percentage points stem from imported goods, 0.9 percentage points from the housing component, and 0.8 percentage points each from domestic goods and domestic services.

The CBI has pointed out recently that it has no influence over imported inflationary pressures. But the remaining three-fifths, based on the list above, do fall under the auspices of the bank to some degree.

The inflation outlook for the next few quarters has deteriorated considerably since the last Monetary Bulletin, published in February. At that time, the CBI forecast that inflation would average 3.1% in 2021 and fall below the bank’s 2.5% inflation target before the year-end. The forecast we published around the same time was broadly similar to this. Now, however, we expect inflation to prove considerably more stubborn, hovering close to the upper deviation threshold of the target this year and not falling back to target until well into 2022. Strong imported inflationary pressures, rapidly rising house price inflation, and steep rises in domestic wage costs all pull in the same direction, with the expected appreciation of the ISK and the slack in the economy pulling in the opposite direction.

Market agents’ near-term expectations have also changed markedly, according to a comparison of the recently published expectations survey and the survey taken before the publication of the February Monetary Bulletin. As can be seen in the chart, at the beginning of 2021, survey participants expected inflation to be in line with target before the year was out. Now they generally expect it not to fall back to target until spring 2022.

However, long-term inflation expectations will ultimately determine the MPC’s assessment of the need for monetary tightening. In March, Committee members were concerned about the slight rise in inflation expectations but considered it too soon to determine whether expectations had become less firmly anchored to the inflation target.

Based on developments in the breakeven inflation rate in the bond market and market agents’ long-term expectations, the situation is something of a mixed bag. The five-year breakeven rate is currently about 3.3%, up from 2.8% at the time of the MPC’s March interest rate decision. But the breakeven rate should be approached with a degree of caution, as the indexed and nominal yield curves are both quite steep these days, and developments in underlying yields could well be explained to some extent by one-off factors. On the other hand, the newly released market expectations survey reveals the broadly held belief that inflation will be close to target, on average, over the next 5-10 years. This must surely help to ease the MPC’s concerns. But it should also be noted that market agents think a considerably higher policy rate will be required in coming quarters to bring this about.

Rising inflation and inflation expectations by some measures have caused the real policy rate to fall somewhat in 2021 to date. Although it is sensible to maintain an accommodative monetary stance at present, it can be argued that there is no need to keep the stance considerably looser now than when the pandemic was raging and uncertainty at its peak. A policy rate hike would move the real policy rate closer to where it was in H2/2020.

Monetary tightening to continue starting in late 2021

The outlook for the policy rate in coming quarters has changed since our last forecast. As before, we expect a relatively slow monetary tightening phase, but we now expect it to start earlier than previously thought because of higher inflation, resilient domestic demand, and a changed interest rate outlook abroad, among other factors. As can be seen below, the revised forecast is broadly in line with changed market expectations in recent months.

After the policy rate hike in May, we expect the CBI to stay its hand until it is absolutely clear that the economic recovery is well underway. Then, in Q4/2021, the Committee will begin raising interest rates at a pace of around 0.25 percentage points per quarter. As always, though, the uncertainty about the policy rate path increases further out the horizon, and the interaction between falling inflation and the narrowing slack in the economy will determine the pace of rate hikes to come.