When the MPC met in August, all members agreed to raise the policy rate, yet two of the five would have preferred a larger rate hike than the 0.25 percentage points ultimately agreed upon.

According to the minutes from the August meeting, the arguments for various interest rate decisions can be summarised as follows:

Key arguments for an unchanged policy rate:

• Uncertainty about the Delta-driven wave of COVID-19
• The current inflation rate could be attributed in part to temporary factors that would soon subside
• Inflation expectations had fallen by some measures
• There was only a short time between MPC meetings, and the outlook could grow clearer before the next meeting

Key arguments for a rate hike:

• Inflation more persistent than expected, and a return to target would take longer
• High and persistent inflation could lead to a further rise in inflation expectations
• Signs that domestic demand had rebounded strongly (card turnover, household lending growth, real estate market)
• The recovery of the labour market was stronger than expected, and the slack in output smaller
• It would be better to raise rates immediately and reduce the likelihood of large rate hikes later

Arguments in favour of a 50-bp rate hike:

• Uncertainty had subsided due to successful vaccination efforts
• Weaker links between public health measures and economic activity, owing to the adaptability of companies and the general public
• Summer tourist numbers were higher than expected
• The GDP growth outlook had improved markedly

To continue in this vein, here are some of the arguments we expect the MPC to consider in its October decision:

As previously mentioned, we believe that the arguments for rate hike will carry the day.

Surge in economic activity

Shortly after the last policy rate decision, Statistics Iceland (SI) published the national accounts for H1/2021. According to the accounts, the post-COVID recovery seems to have gained considerable momentum in Q2, with growth of just over 7% year-on-year driven mainly by growing private consumption and investment, although exports picked up as well.

In our newly published macroeconomic forecast, we assume that GDP growth will be somewhat more front-loaded than we previously projected. This is due not least to strong growth in domestic demand early in the forecast horizon. On the other hand, we forecast that export growth will rebound a bit later than we previously assumed, although we expect it to be robust further ahead.

Various indicators imply that a relatively swift economic recovery is in the cards. Sentiment among executives and the general public has improved markedly in recent months. Payment card turnover has been growing apace, unemployment has fallen steeply, and imports relating to domestic demand have been strong.

Furthermore, uncertainty about the short-term economic outlook has subsided somewhat since the last policy rate decision. The Delta wave of the pandemic has abated and appears to have reached some sort of equilibrium for the present, with daily case numbers in the 20-30 range and hospital admissions well within the healthcare system’s capacity.

The recent Parliamentary elections will doubtless be discussed at the MPC’s next meetings. It appears quite likely that the current Government coalition will remain in power, which will presumably be gratifying to the MPC, as the current Government’s fiscal plan provided for steadily increasing fiscal consolidation in the next few years. But if the new Government has not been formed by the middle of next week, MPC members could view short-term political uncertainty as grounds to leave the policy rate unchanged, since the next rate-setting date is close at hand. That said, even though this is a possibility, we do not expect it to be of pivotal importance for the upcoming interest rate decision.

Inflationary pressures strong in the near term

The housing market has been vibrant in the recent term, with soaring prices, limited supply, and a short average time-to-sale. Presumably, the MPC will consider this grounds for a rate hike, and for two reasons: first, it indicates that households’ position is generally robust despite last year’s downturn, and second, house prices have been growing steadily stronger as a driver of inflation in recent quarters. Of the September inflation measurement of 4.4%, 1.9 percentage points are due to the housing component of the CPI.

The CBI’s recent decision to cap the debt service-to-income (DSTI) ratio on mortgage loans at 35% (40% for first-time buyers) indicates how concerned the bank is about the rise in household debt due to soaring house prices. The maximum DSTI ratio would not have much impact on recently issued loans, but it could start to bite if the interest burden on new debt increases to any marked degree. The CBI’s interest rate policy will therefore work together with the new rules and cool down the housing market in the near future.

The inflation spike that started with the ISK depreciation roughly 18 months ago has been more persistent than previously hoped. Early on, imported inflation was the main driver, but domestic factors have recently taken the centre of the stage, causing most of the more than 4% inflation seen in 2021 to date.

In our macroeconomic forecast, we project that inflation will remain somewhat above 4%, the upper deviation threshold of the CBI’s target, over the next few months, measuring 4.4% at the year-end. It will then subside slowly and steadily next year, aligning with the CBI’s 2.5% target in Q4. We expect inflation to average 3.0% in 2022 and 2.5% in 2023.

Are inflation expectations easing upwards?

Fortunately, long-term inflation expectations have not diverged significantly from the inflation target, according to the available surveys. The MPC gives close consideration to such measurements, as it would give cause for major concern if businesses, households, and the financial sector should begin to lose confidence in the inflation target’s long-term attainability. Although new surveys have not been published since the last rate decision for the latter two groups, a newly published survey among business executives indicates slightly improved 12M expectations (3.0%) and unchanged (3.0%) expectations for inflation in 2 years time. This should provide some comfort for the MPC.

The breakeven inflation rate in the bond market tells a less comforting tale, however. These days it is more difficult than usual to interpret the breakeven inflation rate in the bond market, as yield curves are very steep and their slopes are somewhat irregular. The chart above should be interpreted with this in mind. Nevertheless, we think it fairly clear that the breakeven inflation rate has risen somewhat in the recent past, which will surely be a thorn in the MPC’s side.

An ongoing rate hike path in the cards

We consider it obvious, based on the MPC’s recent statements and actions, that the CBI has begun a monetary tightening phase that it intends to pursue decisively in the coming term unless there is a severe setback in the economic recovery.

The next step could come in mid-November, although we think it more likely that the CBI will wait until the turn of the year. Thereafter, we expect rate hikes on all three decision dates in H1/2022. This would bring the policy rate to 2.5% around the time we expect inflation to return to target and raise the real policy rate to zero by that measure a year from now. After that time, we forecast a policy rate of 0.25 percentage points in each quarter until mid-2023. If this materialises, the policy rate will be 3.5%, which we consider close to its equilibrium level for the years to come, assuming target-level inflation and an acceptable rate of GDP growth. Interest rates could therefore hover around 3.5%, on average, in the next few years, although they will certainly continue to fluctuate in tandem with the inflation outlook and the business cycle position.