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Unchanged policy rate: the MPC’s waiting game

The decision to hold the policy interest rate unchanged, announced on Wednesday by the Central Bank (CBI) Monetary Policy Committee (MPC), was something of a surprise. In reaching its decision, the MPC gave particular consideration to a number of factors, including growth in deposits, lower inflation expectations, the increase in the real policy rate, and signs that previous rate hikes are having a growing impact. The Committee appears to be playing a waiting game, in anticipation of the CBI’s new macroeconomic and inflation forecasts in November, but it is quite likely that the monetary tightening phase is at an end for now.

The CBI announced on Wednesday that the MPC had decided to hold the policy rate (the rate on seven-day term deposits) steady at 9.25%. The decision was somewhat out of sync with official forecasts. We had forecast a rate hike of 0.25 percentage points, but other analysts generally expected a larger increase. However, the MPC’s rationale for keeping interest rates unchanged was in line with the points that we thought argued most strongly against a rate hike at this time. Clearly, those considerations weighed more heavily than the arguments in favour of a rate hike.


The highlights from the MPC statement are as follows:

  • Economic developments have been broadly in line with the Committee’s assessment in August.
  • Inflation has risen, but underlying inflation has tapered off slightly.
  • There are signs that price increases are somewhat less frequent than before, and less widespread.
  • Inflation expectations are still too high but have fallen by some measures.
  • Economic activity lost pace year-on-year in H1/2023, and indicators imply that growth in domestic demand has eased even further in Q3.
  • On the other hand, the labour market and the economy as a whole remain relatively tight.
  • The Bank’s real rate has risen in 2023 to date, however, and the impact of policy rate hikes has started to come more clearly to the fore.

Deposit growth and a rising real rate help …

At the press conference following the interest rate announcement, it emerged that the MPC had taken account, among other things, of the marked increase in household deposits concurrent with indicators of a slowdown in private consumption growth. When questioned, Governor Ásgeir Jónsson said he thought competition in the deposit market supported monetary policy efficacy more in Iceland than in some places abroad. He noted that officials from some of the world’s leading central banks were concerned about how slowly policy rates passed through to financial institutions’ deposit rates. In Iceland, however, it was possible to earn positive real returns on savings without a significant commitment period.

Furthermore, the MPC clearly places strong emphasis on the change that has taken place in the real policy rate in recent quarters. As we pointed out last week in our policy rate forecast, the real rate has risen markedly by most measures over this period. In our opinion, some measures of the real rate indicate a fairly tight monetary stance, but on balance, they no longer suggest an accommodative policy stance, as they did early in the year.

The Governor mentioned at the press conference that a further rise in the real rate would probably be needed in the next few quarters. He expressed the hope, though, that such an increase could be achieved through a decline in inflation and inflation expectations rather than through further nominal policy rate hikes.

Actually, it is mainly a comparison of twelve-month inflation (8.0% in September) with the policy rate (9.25%) that suggests the real rate is low. But we have pointed out repeatedly that this method is not terribly illustrative of the real rate at any given time, as it involves looking in the rear-view mirror with one eye and looking ahead with the other. For instance, this September’s rise in twelve-month inflation is due more to an unusual measurement in September 2022 (which dropped out of the headline inflation measurement now) than to a significant rise in prices this autumn.

If recent developments in inflation are measured in terms of annualised three-month rises in the CPI, the picture changes radically. As the chart indicates, short-term inflation as measured using this method has eased substantially since the spring. It is appropriate to remember, though, that short-term inflation is considerably more volatile than twelve-month inflation, and the CBI’s inflation target is based by definition on the twelve-month rise in the CPI.

… as do declining inflation expectations

Wednesday’s MPC statement points out that inflation expectations have fallen recently by some measures, although they remain too high. This probably refers to new measurements of households’ and businesses’ inflation expectations as published in the CBI’s Economic Indicators, released at the end of last week. In what must have been a relief to the Committee, these groups’ inflation expectations have fallen considerably relative to the previous survey, published early this summer.

It also emerged at the press conference that the MPC does not interpret the breakeven inflation rate in the bond market literally at the present time. As we have discussed recently, the breakeven rate includes an inflation uncertainty premium and therefore cannot be interpreted as an unalloyed reflection of market agents’ assessment of likely developments in medium-term inflation.

A waiting game or the end of the tightening phase?

The forward guidance in Wednesday’s MPC statement is neutral. It is well to remember, though, that neutral forward guidance does not mean the Committee is not issuing any signals about what is to come. It simply means that the Committee does not think a rate hike is significantly more likely than an unchanged policy rate on the next decision date. But the wording of the MPC’s forward guidance is somewhat unusual, at least in comparison with recent statements (see bold-faced emphasis).

It reads as follows:

  • At this point in time, there is some uncertainty about economic developments and about whether the current monetary stance is sufficient. The MPC has therefore decided to await further developments, as the Bank’s new macroeconomic and inflation forecast will be available at its next meeting. Near-term monetary policy will be determined by developments in economic activity, inflation, and inflation expectations.

We interpret this wording to mean that the CBI’s next forecast, set for publication concurrent with the November interest rate decision, could be the deciding factor in whether this monetary tightening episode has come to an end or whether another interest rate hike will be implemented at that November meeting. Presumably, some MPC members would have preferred to raise the policy rate this time but accepted this waiting game as a compromise, given that the intervals between MPC meetings are short in the autumn. If the CBI’s forecasts are in line with our most recent macroeconomic forecast, there is a good chance that this spate of interest rate hikes is at an end, at least for the present.


Jón Bjarki Bentsson

Chief economist