We project that the Central Bank of Iceland (CBI) Monetary Policy Committee (MPC) will decide to hold the bank’s policy interest rate unchanged on 25 August, its next decision date. The policy interest rate (or key rate), which is the rate on seven-day term deposits, will therefore remain steady at 1.0%, where it has been since May. We expect heightened uncertainty about the economic recovery in coming months, owing to the setback in the pandemic, to weigh heavier than persistent inflation and a worsening near-term inflation outlook in the Committee’s deliberations. Furthermore, the threat inflation poses to monetary policy is mitigated by the fact that long-term inflation expectations still appear to be anchored relatively firmly to the CBI’s inflation target.
Our forecast: unchanged policy rate on 25 August
We project that the Central Bank (CBI) Monetary Policy Committee (MPC) will hold the policy interest rate unchanged at 1.0% at its rate-setting meeting next week. We expect the MPC to take the view that growing uncertainty about the short-term economic outlook due to the Delta variant-fuelled wave of the COVID-19 pandemic outweighs the worsening short-term inflation outlook. A monetary tightening phase will probably begin in November, with the policy rate hitting 2.0% by end-2022.
In May, MPC members agreed to raise the policy rate by 0.25 percentage points in order to keep expectations anchored at target and respond to Q1 inflation, which turned out both higher and more persistent than anticipated. One member, Gunnar Jakobsson, would have preferred a 0.5-point rate hike, however. The possibility of keeping rates unchanged was not discussed at the Committee’s May meeting.
High and rising inflation, an improving economic outlook, and rising short-term inflation expectations were among the arguments in favour of a larger rate hike at the May meeting. Arguments for a smaller rate hike centred on high unemployment, the fragility of the economic recovery, moderate long-term inflation expectations, and the fact that some of the current inflation was temporary in nature. In the end, the Committee opted for the smaller increase of 0.25 points.
Since the May decision, the short-term inflation outlook has deteriorated, but economic uncertainty has increased. The anchor to the inflation target still seems relatively firm. About a month after the May rate hike, the CBI’s Financial Stability Committee announced that the maximum loan-to-value (LTV) ratio on new consumer mortgages would be lowered from 85% to 80% for all except first-time homebuyers. Although the main purpose of that action was to arrest the accumulation of systemic risk due to the rapid rise in house prices, the combination of reduced LTV ratios and higher mortgage rates following the May policy rate hike will probably cool the housing market, although it remains quite buoyant.
Heightened uncertainty, courtesy of the Delta variant
Near-term economic uncertainty has increased markedly since the Delta variant of the coronavirus began raging in Iceland in late July, giving rise to what is often called the fourth wave of the pandemic. Until then, most indicators implied that the economy would right itself sooner than forecasts had indicated. According to the Icelandic Tourist Board, 110,000 foreign tourists visited Iceland in July, the largest single-month figure since February 2020. Furthermore, indicators such as payment card turnover, capital area traffic volume, and new motor vehicle registrations showed a rapid increase in domestic activity during the spring, and household and business sentiment improved rapidly in the first half of the year. Since then, unemployment has fallen markedly, and registered unemployment was down to 6.1% in July, its lowest since the onset of the pandemic.
According to recent macroeconomic forecasts, output growth is projected to measure 2.7-3.7% in 2021 and strengthen even further in 2022. These forecasts generally assume that tourism will continue to recover as the year advances and that domestic demand will gain strength in coming quarters.
The setback in the COVID-19 pandemic, both domestically and globally, could put a spanner in the works here in Iceland. At the beginning of the year, we projected that, if this year’s tourist numbers turned out no stronger than last year’s, GDP growth would be approximately 2 percentage points lower than in our baseline forecast, which assumed that tourist arrivals would nearly double year-on-year. It is still too early to say whether the current COVID wave will have that strong an impact on economic developments, but we think it likely that the MPC will consider it more prudent to wait for greater clarity on the Delta situation before changing the policy rate.
Inflation target still provides a sturdy anchor despite high inflation
The inflation outlook has deteriorated steadily in 2021 to date. Inflation measured 4.3% in July and has been consistently above 4%, the upper deviation threshold of the CBI’s inflation target, since the turn of the year. Inflation is driven increasingly by domestic factors such as housing and services prices, while imported inflation has subsided steadily. In July, the housing component accounted for just over a third of headline inflation, domestic services another 3/10, domestic goods just over 1/10, and imported goods a scant 3/10. As these figures show, inflationary pressures stem from a number of sources at present.
In May, the MPC considered this trend cause for concern, as can be seen in its statement from that meeting:
Inflation has therefore been higher and more persistent than previously forecast, measuring 4.6% in April. Inflationary pressures appear to be to be widespread, as underlying inflation is broadly similar to measured inflation. This is due to a number of factors, including the depreciation of the króna in 2020 and steep rises in wages and house prices. As a result, it is necessary to raise the Bank’s interest rates in order to ensure that inflation expectations are anchored to the target.
Moreover, the minutes of the MPC’s May meeting imply that the rapid rise in inflation prior to the meeting and the fact that inflation had been above the 4% tolerance limit since the turn of the year justified a larger policy rate increase than was ultimately decided on.
The short-term inflation outlook has grown bleaker since the May interest rate decision. In its May forecast, the CBI projected inflation at 4.0% in Q3 and 3.8% in Q4, but our most recent forecast puts inflation at 4.3% and 4.1%, respectively, in the same quarters. Market agents’ near-term inflation expectations have developed similarly, according to the most recent survey: respondents now expect inflation to be an average of roughly 0.6% higher through mid-2022 than they did in May.
But it must provide the Committee with a degree of comfort to see that this stubborn inflation episode has not yet affected the long-term outlook to any marked degree. The most recent data indicate that by most measures, long-term expectations are still within striking distance of the target – in our opinion, a sign of the credibility that the CBI’s monetary policy still enjoys among the public, headwinds notwithstanding. The fact that long-term expectations are still anchored to target was mentioned explicitly as an argument for a smaller rate hike at the Committee’s May meeting.
Monetary stance generally deemed appropriate
In recent months, the real policy rate has been relatively stable, as the CBI responded to the slide in the spring by raising the nominal policy rate in May. At present, the real rate is negative by 1.9-3.0%, depending on the measure used.
According to the CBI’s newly published market expectations survey, 2/3 of respondents consider the monetary stance appropriate, up from just over half in the May survey. The share of respondents who consider the stance too loose has fallen accordingly, from just under half to one-third. Overall, the reigning opinion in the financial market seems to be that the May rate hike has delivered an appropriate monetary stance.
Market agents’ expectations concerning the policy rate tell a slightly different story, though: according to the median response in the survey, they expect a 0.25-point rate hike in Q3. This doesn’t quite jibe with the above-described views on the monetary stance, as the August interest rate decision is the only one scheduled for Q3, but presumably, market agents are worried that the CBI will tighten monetary policy more than is warranted in the near future.
Monetary tightening to resume in the new year?
Assuming that uncertainty subsides over the course of the autumn and the Delta variant does not prove to be too much of a drag on the tourism industry and the economy more broadly, we think it likely that the MPC will raise the policy rate by 0.25 percentage points before the year-end. Whether this happens in October or November will probably depend on how quickly the near-term economic outlook clears up. A rate hike in November is the likelier outcome, though, as the CBI is set to publish in-depth macroeconomic and inflation forecasts at that time, and hopefully the path of the pandemic will be clearer by then.
Thereafter, we expect a rate hike of 0.25 percentage points each quarter for the next two years. It is worth remembering that the MPC’s regular rate-setting meetings take place six times each year, so a rate increase at each and every meeting is probably not in the cards. As always, 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.
If the pandemic persists and causes a severe setback in the economic recovery, the entire process will be delayed. On the other hand, if inflation remains persistent and stems from domestic causes that are within the CBI’s purview, it could be expedited. All of this will depend not least on whether house price inflation eases in coming quarters and whether the next wage agreements (expected late next year) are more consistent with the inflation target than those currently in effect.