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The last policy rate hike for the time being?

We project that the Central Bank’s (CBI) policy interest rate will be raised by 0.25 percentage points next week. Declining inflation and reduced demand pressures in the economy are the main reasons for the CBI to implement a smaller rate hike than before. If the economy evolves in line with the current outlook, there is a good chance that this will be the last policy rate increase for the present and that a gradual monetary easing phase will ensue.

We project that the CBI’s Monetary Policy Committee (MPC) raise the policy rate 0.25 percentage points on 23 August, the next rate-setting date. If this forecast is borne out, the key interest rate will be 9.0%, its highest since early 2010. We expect the MPC to discuss the possibility of keeping the policy rate unchanged as well but ultimately decide to raise it by 25 bp. If this is indeed the outcome, we think it quite likely that the MPC will stop there and keep the policy rate unchanged for the remainder of the year.

On the MPC’s last interest rate decision date, in late May, it took a huge stride and raised the policy rate by 1.25 percentage points. At that meeting, members discussed rate hikes ranging between 1.0 and 1.5 percentage points. For the first time since October 2021, a Committee member voted against Governor Ásgeir Jónsson’s proposed 1.25-point rate hike, when Deputy Governor Gunnar Jakobsson cast a “no” vote, specifying his preference for a 1-point increase.

The MPC statement was uncompromising, and the forward guidance read as follows: “… the outlook is for further rate hikes in order to ensure a better balanced economy and bring inflation back to target.” This signalled clearly that MPC was determined at the time to continue ratcheting up the monetary stance.

The impact of rate hikes has come to the fore

We expect the MPC to take a considerably smaller step upwards this time, as most statistics have developed favourably since the May decision. Chief among them are headline inflation, which has fallen rather quickly, and the inflation outlook, which has brightened somewhat. At the time of the last policy rate decision, twelve-month inflation stood at 9.9% and had been over 9% for roughly a year. But this summer, inflation finally started to give some quarter and is now down to 7.6%, mainly because of a drop in house prices and lower imported inflation. The outlook is for an even further decline in August, according to ÍSB Research’s new inflation forecast. Moreover, core inflation, which excludes volatile items, has fallen by all measures in recent months. This comes as a great relief, as the MPC pays close attention to core inflation in its assessment of underlying inflationary pressures.

Our most recent inflation forecast is considerably more upbeat that the one issued by the CBI concurrent with the policy rate decision in May. At the press conference following that interest rate announcement, the Governor said the MPC’s goal was to prevent the May inflation forecast from materialising. We think that effort has borne fruit and that there is no need for a rate hike larger than 25 basis points next week. It is common knowledge that inflation is still a few light-years away from the CBI’s target. Nevertheless, it must also be very welcome news for the MPC that it has finally begun to fall in earnest and the recent rate hikes have started to bite.

Short-term inflation expectations have improved

The CBI also considers inflation expectations when it sets interest rates, and earlier this week it published the results of its market expectations survey. Short-term expectations have improved a bit between surveys. Market participants expect inflation to measure 5.6% a year from now, down from 6.3% in the last survey. Their two- and five-year expectations are unchanged between surveys, but their long-term expectations have risen marginally, with survey respondents expecting inflation to measure 3.6% ten years from now. As these numbers show, inflation expectations over the next several years are still well above the CBI’s 2.5% inflation target, and the MPC wants to see them move closer to target.

Economic activity has eased

Clearly, economic activity has subsided in the past few months, and the recent policy rate hikes have dampened demand. Payment card turnover contracted in real terms for four months running and then remained flat year-on-year in July.

Private consumption grew by just under 5% in Q1/2023, after increasing by nearly 9% in 2022, and most indicators imply a far weaker growth rate for the remainder of the year. The Q2/2023 national accounts are scheduled for publication at the end of the month and will therefore not be available to the MPC in time for the policy rate decision, but most indicators suggest that economic activity has lost quite a bit of steam, and we can only assume that the MPC will be very relieved.

Monetary easing to begin in 2024

Most economic indicators have developed favourably since the MPC’s last interest rate decision. Even so, we think the Committee will prefer to tread lightly, perhaps rounding out the current monetary tightening phase with a final 25-bp rate hike. If it does, this would be the MPC’s fourteenth consecutive rate increase. If the outlook remains unchanged, we think it quite likely that this will indeed mark the end of the current episode, but if the past year has taught us anything, it is that we can take nothing for granted on that score. We expect the MPC to start lowering the policy rate gradually in H1/2024 as disinflation picks up speed and the economy becomes better balanced.


Bergthora Baldursdottir




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