In May, the MPC’s five members voted unanimously to raise the policy rate by 0.25 percentage points. According to the minutes from that meeting, the Committee considered two options: a rate hike of 0.25 percentage points or a hike of 0.5 points. As is noted above, it ultimately decided to raise interest rates by the smaller amount, 0.25 points, but members agreed that they should explicitly express their willingness to raise rates higher if necessary. The key drivers of the MPC’s May decision included the following: 

• Inflation had been over 5% in 2026 to date and measured 5.2% in April. 
• Inflation expectations had risen, particularly short-term expectations. 
• Nevertheless, they had risen less since the onset of the Persian Gulf conflict than in the wake of Russia’s invasion of Ukraine four years earlier – not least because the economy was running considerably hotter in 2022. 
• According to the CBI’s forecast, the outlook was for weaker GDP growth and higher unemployment than had been projected earlier. 
• At the same time, a surge in oil and commodity prices and persistent domestic inflationary pressures had caused the inflation outlook to deteriorate as well. 
• The economic outlook could worsen further if disruptions in the global oil market lasted longer than was assumed at that time, or if wage agreements were terminated later in the year. 
• In view of the poorer inflation outlook and high inflation expectations, the MPC considered it appropriate to increase the CBI’s interest rates. 

Summarised below are several of the factors that MPC members will doubtless ponder as they deliberate on next week’s interest rate decision: 

As is stated above, we think the scales will tip in favour of a rate hike this time. 

The economy is sailing close to the wind 

Developments and prospects for Iceland’s economy have held broadly unchanged since we published our macroeconomic forecast in early June. GDP growth still looks set to be subdued this year, with high real interest rates, an ongoing labour market adjustment, and a temporary setback in several export sectors impeding economic activity. Thus far, the peak tourist season has been a bit weaker than we had expected, although the difference is rather slight. In 2026 to date, foreign nationals’ departures via Keflavík Airport have declined by just over a percentage point relative to the first seven months of 2025.  

 On the other hand, households and businesses stand on solid ground overall, real wages have been on the rise despite high inflation, private consumption has proven more resilient than expectations surveys might indicate, and there are signs that the outlook for non-tourism exports has improved rather than worsening in recent months. Therefore, our baseline scenario still assumes that the economy will navigate the quarters ahead without shrinking, although it would not require much for tepid growth to flip to a short-lived contraction. 

The slack in the economy has widened steadily, however. Unemployment has risen from the trough of the past few years, immigration has slowed markedly, and labour shortages are far less acute than before. House price inflation has eased, supplies have increased, and the impact of higher debt service has grown more visible. This suggests that domestic inflationary pressures will keep subsiding over the course of 2026, albeit at a slower pace than was hoped earlier in the year. 

The ISK has been remarkably stable recently, notwithstanding Iceland’s current account deficit and the highly uncertain global economic environment. Inflows of investment-related foreign capital, Iceland’s strong international investment position, and the continued interest rate differential with abroad have all supported the currency. We still think it likely that the ISK will depreciate slowly over time, as the real exchange rate is historically high and both prices and wage costs rise faster in Iceland than in key trading partner countries. 

Overall, then, the economic outlook remains ambiguous. The slack in the economy is growing and, in all likelihood, will ultimately contribute to further disinflation. That said, robust demand, persistent inflation, and high inflation expectations indicate that the large slack in the economy is taking longer than expected to bring about reduced inflation and inflation expectations. The domestic economy still appears to be sailing in choppy waters but is well ballasted. 

Inflation digs its heels in

Since the last policy rate decision, inflation has proven more stubborn than most observers had hoped. Headline inflation rose from 5.1% in May to 5.2% in June and 5.3% in July.  

Of particular concern is the fact that various measures of underlying inflation have not improved as perhaps they should have. By most measures, inflation according to various core indices has either stood still or eased upwards in recent months, implying that underlying inflationary pressures may well be growing rather than shrinking. Even though house price inflation has retreated from the peaks seen in recent years, this has not sufficed to offset the inexorable rise in the price of public and private services, food, and other domestic items. Overall, inflation remains widespread and is not limited to a few volatile items. 

The short-term outlook suggests that inflation will inch upwards again in the months ahead. Based on our preliminary forecast, it will rise to 5.4% in August and 5.5% in September. This is due partly to base effects, as favourable index measurements from 2025 are set to drop out of twelve-month measurements. Furthermore, the temporary reduction in value-added tax on fuel is about to expire, and the increase in standard fees for healthcare centre visits will push inflation upwards. In spite of the obvious slack in the housing market and weaker growth in domestic demand, it still looks as though the final leg of the journey back to the inflation target will be an arduous one. If anything, recent inflation measurements have corroborated the view that underlying inflation is more deeply entrenched than developments in the CPI alone would indicate. 

In May, the CBI forecast that inflation would average 5.0% in Q2 and 5.2% in Q3. The actual figure for Q2 turned out to be 5.2%, and the Q3 inflation rate will probably be 5.4%, if our preliminary forecast materialises. Short-term developments in inflation are therefore unlikely to bring a smile to MPC members’ faces. It will be interesting to see the CBI’s inflation forecast when the next Monetary Bulletin is published. In May, inflation was forecast to remain above 5% for all of 2026 and then fall rather quickly in 2027. In our assessment, the CBI’s forthcoming inflation forecast is likelier than not to provide for a slower disinflation rate.  

It certainly doesn’t help that the assumptions clause in wage agreements, which stipulates that inflation must be below 4.7% in August, will not hold, thereby triggering a review of most contracts. This could lead to larger year-end 2026 pay rises than are included in the current wage agreements. The August inflation measurement will not yet be available when the MPC convenes next week, but even so, the assumptions clause is a factor that is sure to exacerbate MPC members’ concerns about inflationary pressures in the quarters ahead.

Loosely anchored inflation expectations

At its August meeting, the MPC will give due consideration to inflation expectations, both as measured in surveys and as reflected in the breakeven inflation rate in the bond market. 

The breakeven rate has eased slightly by most measures in the recent past, as yields on inflation-indexed Government bonds have fallen more than yields on comparable nominal bonds. Our calculations suggest that the three-year breakeven rate has fallen by approximately 0.4% since the last interest rate decision, while the five- and ten-year rates have fallen by 0.3 and 0.2 percentage points, respectively. This is one of the few bright spots in the otherwise shadowy inflation picture that MPC members will see next week. By all these measures, the breakeven inflation rate is considerably higher than is consistent with the CBI’s 2.5% inflation target, even after allowing for the fact that it includes an uncertainty premium. We estimate that in the first week of August, the three- and five-year breakeven rates were about 4.0% and the ten-year rate 3.9%.  

A similar tale can be told of survey-based inflation expectations, which have been a burr in the MPC’s saddle in the recent past. No survey data for Q3 are available yet, although the forthcoming market expectations survey results, set for publication on Friday morning, could provide important information for next week’s MPC meeting. Developments between Q4/2025 and mid-2026 have hardly been to the MPC’s liking, however. 

Households’ five-year inflation expectations have risen from 4% to 5% over this period, and corporate expectations have risen from 3.5% to 4.0%. Market agents’ long-term expectations have changed less markedly, rising from 3.0% to 3.2% over three- and five-year horizons and remaining unchanged at 3.0% over a ten-year horizon. It goes without saying that this is not the pattern the MPC wants to see after two rate hikes in H1/2026 and a discernible tightening of its forward guidance.  

How tight is monetary policy?

Ultimately, the purpose of the CBI’s interest rate decisions is not to affect the short-term interest rates offered to its own customers but to make an impact on the overall interest rate level in the country, thereby affecting consumption, investment, and saving. Thus the MPC wants to see a tighter monetary stance reflected in higher short- and long-term real interest rates. With this in mind, it is interesting to examine various measures of real interest rates and see how they have developed in the recent term.  

There are a number of ways to calculate the real policy rate using various expectations metrics or comparisons with past inflation. Based on the most recent measurements of short-term expectations and the breakeven inflation rate, the real policy rate fell by an average of 0.5% between December 2025 and June 2026, despite a nominal policy rate hike of 0.50 percentage points over the same period. Based on past inflation, the decline measures 0.3 percentage points year-to-date and 0.2 percentage points since the MPC’s May meeting. It should be borne in mind that CBI officials have stated that a real rate of 3% or more is desirable to bring inflation down in the coming term. Our calculations, based on the most recent reference figures on expectations, breakeven rates, and observed inflation, suggest that the real policy rate is currently between 2.3% and 3.5%, below the optimal level described above. 

The same can be said of real rates as depicted in inflation-indexed bonds. By that measure, the real rate has risen by 0.2-0.3 percentage points in 2026 to date and has eased upwards since the May interest rate decision. Long-term reference rates on inflation-indexed bonds – i.e., indexed Government bond yields – are currently in the 2.7-3.7% range, tapering off further out the horizon. By that measure, it could be argued more convincingly that the current monetary stance is appropriate, given that the long-term real interest rate should reflect equilibrium more effectively than the current stance does.  

In our assessment, the evolution of short-term real interest rates is more relevant to the Committee’s deliberations than movements in long-term real interest rates in the bond market, and it points instead to monetary conditions not having tightened sufficiently. 

Will interest rates fall again as summer 2027 approaches?

Assuming that our inflation and macroeconomic forecasts prove close to accurate, we think it likely that after the August decision date, the policy rate will be held unchanged at 8% for the remainder of the year. There is little room for error on the inflation front, however, as the CBI could hike rates further in October or November.

With a better-balanced housing market, a cooler labour market, a growing slack in the economy, and – last but emphatically not least – falling inflation, the MPC should have scope to lower the policy rate in 2027. We assume that the unwinding phase will begin before the end of Q1/2027 and end around mid-2028 with a policy rate close to 6.0%. The process could be quicker if there are clear signs of a significant decline in inflation expectations, but on the other hand, more persistent inflation and more firmly rooted inflation expectations could delay a meaningful drop in the policy rate.

LEGAL DISCLAIMER

This report is compiled by Islandsbanki Research of  Islandsbanki hf.

The information in this report originates in domestic and international information and news networks that are deemed reliable, along with public information, and Islandsbanki Research’s own processing and estimates at each time. The information has not been independently verified by Islandsbanki which therefore does not guarantee that the information is comprehensive and accurate. The views of the authors can change without notice and Islandsbanki holds no obligation to update, modify or amend this publication if assumptions change.

This publication is only published for informational purposes and shall therefore not be viewed as recommendation/advice to make or not make a particular investment or an offer to buy, sell or subscribe to specific financial instruments. Islandsbanki and its employees are not responsible for transactions that may be carried out based on information put forth in the report. Before making an investment decision, recipients are urged to seek expert advice and get well acquainted with the investments market and different investment alternatives. There are always financial risks related to investment activities, including risk due to international investments and fluctuations in the exchange rate of currencies. Investors’ investment objectives and financial position vary. Past performance does not indicate nor guarantee future performance of an investment.

The research report and other information received from Islandsbanki are meant for private use only. The materials may not be copied, quote or distributed, in part or in whole, without written permission from Islandsbanki.

This report is a short compilation and should not be considered to contain all available information on the subject it discusses.

Supervisory body: The Financial Supervisory Authority of Iceland (www.fme.is).

UNITED STATES

This report or copies of it must not be distributed in the United States or to recipients who are citizens of the United States against restrictions stated in the United States legislation. Distributing the report in the United States might be seen as a breach of these laws.

CANADA

The information provided in this publication is not intended to be distributed or circulated in any manner in Canada and therefore should not be construed as any kind of financial recommendation or advice provided within the meaning of Canadian securities laws.

OTHER COUNTRIES

Laws and regulations of other countries may also restrict the distribution of this report.

Further information regarding material from Islandsbanki Research can be accessed on the following.