The CBI announced on Wednesday morning that the policy rate would be lowered by 0.25 percentage points, to 3.25%, the lowest in the history of Iceland’s inflation-targeting monetary policy regime. Forecasters had projected either no change or a rate cut. We had forecast that the Monetary Policy Committee (MPC) would keep the policy rate unchanged this month and lower it next month.
Policy rate hits a historical low
The Central Bank of Iceland’s (CBI) policy interest rate is now lower than at any time since the adoption of the inflation target at the beginning of this century. Even though the policy rate has been lowered by 1.25 percentage points year-to-date, further monetary easing before the year-end is likely.
Deteriorating economic outlook; improving inflation outlook
The MPC noted that the outlook is for inflation to ease even faster than the CBI had forecast in August. This is interesting because the August forecast had assumed that inflation would fall back to the target by mid-2020. The CBI’s forecast therefore appears to be moving closer to our own, which assumes that inflation will align with the target before the end of 2019. At this morning’s press conference where CBI officials explained the rationale behind the interest rate decision, it emerged that domestic cost pressures are weaker than previously expected and that Q3 inflation had turned out lower than previously forecast. In addition, inflation expectations had fallen, both in the bond market and according to survey responses.
The MPC is concerned about the near-term economic outlook, not least the bleak outlook abroad and the possibility of contagion affecting Iceland. As we pointed out just recently, the global economic outlook as described in OECD’s most recent macroeconomic forecast is the worst in a decade. According to MPC members, there are signs that the domestic economy will continue to slow down, although there are signs that it may be gaining a foothold. At today’s press conference, Governor Ásgeir Jónsson pointed out a positive development: that domestic demand had shifted increasingly towards domestic goods and services. Examples of this include a significant reduction in purchases of consumer durables such as motor vehicles and, in recent months, a year-on-year decline in Icelanders’ overseas travel. This trend will tend to cushion against the downturn in coming quarters.
Sizeable interest rate cuts to date …
The policy rate has now been lowered by 1.25% since the turn of the year, including 0.50% since the new Governor took over in mid-August. In response to questions about the outlook for interest rates in Iceland further ahead, the Governor pointed out that the Icelandic economy had undergone fundamental changes that, in general, should lead to a lower interest rate level. This applies in particular to Iceland’s external balance, where a persistent current account deficit has given way to a sizeable current account surplus and external assets exceed external liabilities by a comfortable margin. He also pointed out that Iceland is not an island in the economic sense and that low interest rates abroad tend to push domestic rates downwards as well.
It also emerged at the press conference that monetary policy appears to enjoy considerable credibility, if declining inflation expectations are a reliable indicator. This makes it easier for the CBI to mitigate the business cycle in the same way that central banks do in neighbouring countries. In the Governor’s words, lower interest rates can be viewed as the prize for keeping inflation close to target and negotiating sensible wage agreements.
Deputy Governor Rannveig Sigurðardóttir noted, however, that the real policy rate was already quite low. For some time, the short-term real policy rate had been hovering around 0.5%, and MPC members did not want to see it fall much further – certainly not below zero. The state of the economy did not indicate that there was any reason to lower the real rate that much. Furthermore, increased fiscal easing meant that the real policy rate need not fall as low as it might need to otherwise.
… but further easing probably lies ahead
The forward guidance in today’s MPC statement was short and sweet, neutral, and, in fact, a verbatim repetition of the August statement. It reads as follows:
Near-term monetary policy decisions will depend on the interaction between developments in economic activity, on the one hand, and inflation and inflation expectations, on the other.
Even though there is a note of caution in this sentence, we felt that we could sense a relatively mild tone at this morning’s press conference. Based on this and our recent macroeconomic and inflation forecasts, we think the policy rate may not yet have hit bottom. We envision at least one more rate cut before the year-end, and we expect the policy rate to remain low through 2020. The uncertainty in this forecast is tilted to the downside, owing to the possibility of additional incremental rate reductions in coming quarters.