Strong response from the Central Bank

The Central Bank’s (CBI) decision to lower the policy rate and the capital requirements imposed on the commercial banks is a welcome response to the ever-darkening economic outlook. The steps already taken by the authorities will go far to mitigate the economic blows expected in the quarters to come, but it is vital that others make their contributions as soon as possible.


The CBI’s Monetary Policy Committee (MPC) announced this morning that it had decided to lower the CBI’s policy rate by 0.5 percentage points. This brings the key interest rate to 1.75%, after a combined rate cut of 1 percentage point in a week. The CBI also announced that its Financial Stability Committee had decided to lower the countercyclical capital buffer requirement in financial institutions from 2% to 0%. In addition, the bank announced that the buffer would not be reinstated until at least two years from now. The Financial Stability Committee’s decision is consistent with measures taken by other European authorities, who have either dramatically reduced such buffers or eliminated them. These policy actions are an element in the measures taken to mitigate the economic impact both of the COVID-19 pandemic and the measures adopted to slow the spread of the disease.

Lifting the countercyclical buffer gives banks greater flexibility

Lifting the countercyclical capital buffer has a marked effect on banks’ lending capacity. The Financial Stability Committee estimates that, other things being equal, the increased scope for lending could range up to ISK 350bn, or 12.5% of the banks’ current loan portfolio. We have previously stressed the need to lower the capital requirements on the banks, as this is the right time to deploy the substantial equity the banking system has at its disposal.

It emerged in the comments made by Governor Ásgeir Jónsson that the banking system’s combined capital position was currently around 25%, which is unusually strong in comparison with other advanced economies. Ásgeir noted, however, that it would have been appropriate to allow the increase in the countercyclical capital buffer to take effect on 1 February 2020. Furthermore, it was an absolute prerequisite for the reduction of the buffer than the banks pay no dividends this year. The overall condition for this easing of requirements on the banking system was that the funds released must remain “in the banks”, as Ásgeir put it. In other words, the banks must use the scope granted them to cushion against the blow that the COVID-19 epidemic and related measures would deal to the Icelandic economy in the near future.

ISK depreciation not abnormal

The ISK has depreciated by over 10% year-to-date, and the CBI has attempted in recent weeks to smooth out short-term FX market volatility by selling about ISK 8bn worth of foreign currency from its reserves. The Governor stressed at this morning’s press conference, however, that the CBI had not yet intervened in the FX market this week. In his opinion, this depreciation in recent weeks is healthy to an extent, as it improves export sectors’ competitive position and provides for greater resilience when things start moving again.

Ásgeir also mentioned that following a meeting with the CBI, the Icelandic Pension Funds Association had instructed member funds to suspend foreign asset purchases for the present. He pointed out that the funds’ foreign investments had totalled about ISK 120bn in 2019, thereby counterbalancing to a large extent the year’s current account surplus of more than ISK 170bn. It would be appropriate, he said, to take a breather now, during a period of reduced export revenues, as it was highly likely that the pension funds would have plenty of time to resume their foreign asset purchases later. The Governor also thought the foreign exchange market would probably rebalance quickly.

Chief Economist Thórarinn G. Pétursson added that a strong inflationary response was not a given, in spite of the recent ISK depreciation. Reduced domestic demand, for instance, would offset it. The CBI’s macroeconomic forecast from early February assumed that inflation would be below the target through the end of 2019. Thórarinn considered it possible that inflation would rise temporarily above the target this year. Even so, all fears of runaway inflation in the near future were unnecessary. Developments in the breakeven inflation rate in the bond market suggest, in fact, that market agents share this opinion. The breakeven rate has remained relatively moderate, and the long-term breakeven rate is around 2.6% as of this writing.

Ásgeir also mentioned that following a meeting with the CBI, the Icelandic Pension Funds Association had instructed member funds to suspend foreign asset purchases for the present. He pointed out that the funds’ foreign investments had totalled about ISK 120bn in 2019, thereby counterbalancing to a large extent the year’s current account surplus of more than ISK 170bn. It would be appropriate, he said, to take a breather now, during a period of reduced export revenues, as it was highly likely that the pension funds would have plenty of time to resume their foreign asset purchases later. The Governor also thought the foreign exchange market would probably rebalance quickly.

Chief Economist Thórarinn G. Pétursson added that a strong inflationary response was not a given, in spite of the recent ISK depreciation. Reduced domestic demand, for instance, would offset it. The CBI’s macroeconomic forecast from early February assumed that inflation would be below the target through the end of 2019. Thórarinn considered it possible that inflation would rise temporarily above the target this year. Even so, all fears of runaway inflation in the near future were unnecessary. Developments in the breakeven inflation rate in the bond market suggest, in fact, that market agents share this opinion. The breakeven rate has remained relatively moderate, and the long-term breakeven rate is around 2.6% as of this writing.

When questioned, Thórarinn said it was premature to issue updated economic forecasts or scenarios for the coming term. Uncertainty was still too high, and developments too rapid, for such forecasting to have any value. He did say, however, that he considered a contraction in GDP highly likely this year, although there were reasonably strong grounds to expect a recovery to begin as soon as 2021.

Strong messaging boosts confidence

It is safe to say that today’s communication from the CBI was clear and unequivocal. The Governor noted that both the Financial Stability Committee and the Monetary Policy Committee had been unanimous in the decisions announced this morning. Furthermore, the new Central Bank (which merged with the Financial Supervisory Authority at the turn of the year) had a wide range of tools to respond to the current situation. A number of those tools had yet to be used. As the Governor put it, they were just getting started! In addition, the CBI would ensure that the banks had the liquidity they needed in the near future. Moreover, the MPC was authorised to approve quantitative easing measures (CBI purchases of Treasury securities), as central banks around the world have done in the past decade in a bid to lower long-term interest rates. No discussions of how to orchestrate this have taken place yet, however. Many other central banks had interest rates close to zero, and at that point they had embarked on such quantitative easing. In Iceland, however, there was still room to lower interest rates.

Details on mitigating measures from the Government are expected in the days to come. Hopefully, the authorities will take another bold step in responding to the economic crisis, as the Minister of Finance and Economic Affairs has mentioned that he considers a fiscal deficit of ISK 100-200bn likely this year. Furthermore, local governments would have to step forward soon with responses of some kind. In our opinion, however, the steps that have already been taken are likely to soften the economic blow considerably in the near term and hasten the recovery once the current crisis has passed.

Author


Jón Bjarki Bentsson


Chief economist

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