The highlights from the MPC statement are as follows:

• Inflation has been over 5% in 2026 to date and currently measures 5.2%.
• Inflation expectations have risen, particularly short-term expectations.
• However, they have risen less since the onset of the Persian Gulf conflict than in the wake of Russia’s invasion of Ukraine four years ago. This is largely because capacity pressures have eased considerably.
•  According to the Bank’s newly published forecast, the outlook is for weaker GDP growth and higher unemployment than was projected in February.
• At the same time, a surge in oil and commodity prices and persistent domestic inflationary pressures have caused the inflation outlook to deteriorate as well.
• The economic outlook could worsen further if disruptions in the global oil market last longer than is currently assumed or if wage agreements are terminated later this year.
• In view of the poorer inflation outlook and high inflation expectations, the MPC considers it appropriate to increase the Bank’s interest rates.

New CBI forecast assumes weaker GDP growth and higher inflation

As is noted above, the macroeconomic forecast in the CBI’s new issue of Monetary Bulletin assumes that GDP growth will be weaker than was depicted in the last forecast. The new forecast doesn’t exactly sketch out a picture of a recession, though, as it projects GDP growth at 1.6% in 2026 and 2% per year in 2027 and 2028. Nevertheless, the revised forecast entails a considerably larger slack in output during the quarters just ahead, plus a larger rise in unemployment than the CBI had previously projected. Another important point is that the contribution from net trade over the forecast horizon is virtually unchanged between forecasts, which means that the reduced output growth in the new forecast is due almost entirely to weaker growth in domestic demand.

It is striking that even though the conflict in the Persian Gulf is expected to push import prices higher, the CBI projects that terms of trade will improve this year, not least because of favourable developments in the price of aluminium and various marine products. This helps foster better balanced trade and, all else being equal, will support the ISK exchange rate in the near term This is reflected in the CBI’s forecast, in that the exchange rate is projected to hold virtually still over the forecast horizon and the current account deficit to narrow, although subdued import growth and reasonably robust export growth later in the period are key factors as well.

The CBI’s new inflation forecast is considerably more downbeat about the near-term situation than the February forecast was. The bank now projects inflation at 5% and above through the end of this year. As before, however, it expects rapid disinflation in 2027.

The CBI’s forecast assumes as well that the assumptions clause in wage agreements will be triggered this autumn. The bank assumes that the contracting parties will ultimately reach an agreement entailing additional pay hikes, effective at the end of 2026, to compensate for inflation in excess of the 4.7% threshold specified in the assumptions clause. We interpret this to mean that the CBI expects a 4.0% increase in wages at the year-end instead of the 3.5% provided for in most wage contracts.

The new issue of Monetary Bulletin includes an alternative scenario in which wage agreements are reviewed and wages boosted by 1% more than is assumed in the baseline forecast. This can be construed to mean a 5% general pay rise at the end of this year. If this scenario should materialise, more persistent inflation and the CBI’s response to it would result in far fewer hours worked and weaker output growth in 2027 and 2028 than would otherwise occur.

Limited scope for general pay rises

The new Monetary Bulletin also contains a Box analysing how much wages can rise in coming years and still be consistent with the inflation target. In that analysis, the bank estimates this scope for target-consistent wage rises at 3.7%, on average. After taking account of additional pay increases for low wages, usually a part of wage agreements, plus wage drift, the CBI concludes that negotiated pay hikes may not be much larger than 2% if inflation is to be at target. It is well to remember that wage agreements in recent decades have generally provided for pay rises about twice that size, and it is therefore clear that something in the collective bargaining process has to give if the target is to be reached and maintained in the foreseeable future. According to the discussion in the Box, 2% wage growth in the eurozone and Sweden has been in line with target-level inflation in the past two decades or so.

Is the current policy rate sufficient?

The forward guidance in today’s MPC statement is nearly identical to that in March. It reads as follows:

The Committee is also prepared to tighten the monetary stance still further to ensure that inflation eases towards the target, even though this could further curtail economic activity. Nevertheless, monetary policy formulation will be determined, as before, by developments in economic activity, inflation, and inflation expectations.

For the sake of comparison, the May statement is as follows:

Furthermore, the Committee is prepared to tighten the monetary stance still further to ensure that inflation eases towards the target, even though this could further curtail economic activity. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

(The only substantive change is the addition of the word “nevertheless” in the new statement.)

We interpret the MPC statement to mean that the Committee wants to give the summer the benefit of the doubt as regards inflation. We assume that there was considerable discussion of a larger rate hike at the MPC meeting, but unambiguous signs of economic cooling and the larger slack provided for in the new forecast may well have tipped the scales in favour of the smaller one. In our assessment, the consensus among Committee members on a modest rate increase reduces the likelihood of another rate hike in August. That said, an August rate increase cannot be ruled out, especially if inflation develops even more unfavourably than the CBI forecasts.

Our preliminary forecast is unchanged from last week’s policy rate forecast. We expect the policy rate to hold steady at 7.75% through end-2026 and a gradual monetary easing phase to begin early in 2027. There is limited margin for error, though, and it would not take much to prompt further rate hikes. In our assessment, the uncertainty in the policy rate forecast is tilted to the upside.