Policy rate hike in response to rising inflation and a recovering economy

The Central Bank of Iceland’s (CBI) policy interest rate has been bumped back up to 1.0% after this morning’s announced rate hike. A bleaker short-term inflation outlook and a brighter economic outlook than previously expected tipped the scales towards a rate hike, as we had anticipated. The CBI now forecasts stronger GDP growth than before, although it expects unemployment to be stubborn and inflation quite high in the short run.


The CBI’s policy interest rate will be 1.0% once again, as it was from May until November 2020. The CBI’s Monetary Policy Committee (MPC) announced this morning that it had decided to raise the CBI’s policy rate by 0.25 percentage points. The move was in line with our forecast, but opinion was divided during the run-up to the decision, as conditions in the economy have changed rapidly in the recent past.

In the MPC’s opinion, the economic recovery in H2/2020 was stronger than previously thought, and the outlook for the upcoming recovery has improved, according to the new macroeconomic forecast published in today’s issue of Monetary Bulletin. Unemployment had begun to ease, although it remained high, and the slack in the economy appeared to be smaller and looked set to close sooner than previously estimated.

Furthermore, the MPC cited higher and more persistent inflation than previous forecasts had assumed, as well as widespread inflationary pressures and the fact that underlying inflation and CPI inflation were broadly similar at present. Because of all this, the Committee considers it necessary to raise interest rates in order to ensure that inflation expectations are anchored to the CBI’s 2.5% target.

The forward guidance in today’s statement was short and sweet, reading as follows:

The MPC will apply the tools at its disposal to ensure that inflation eases back to the target within an acceptable time frame.

Although laconic, this statement clearly implies the probability of further rate hikes if inflation does not subside in the next few months.

CBI relatively unconcerned about the housing market, according to today’s press conference

At the press conference following the interest rate announcement, it emerged that despite the spike in house prices in recent months, MPC members are not greatly concerned about the housing market just yet. According to the Committee, prices in the market are supported by fundamentals, and demand pressures could prove temporary. Furthermore, it was pointed out that four years ago the pace of house price inflation had eased decisively after a temporary upsurge.

The CBI’s relative lack of concern took us somewhat by surprise. In April, the housing component was responsible for 20% of twelve-month inflation, and we expect rising house prices to make their mark on the CPI in coming months. The market appears fairly hot at the moment, and according to recent figures from Registers Iceland, twelve-month house price inflation in the capital area measures 13.7%, its highest since the end of 2017, when the market was beset by demand pressures and prices spiralled out of control.

In addition, Governor Ásgeir Jónsson and Deputy Governor Rannveig Sigurðardóttir pointed out that measures to tighten mortgage lending were not under the auspices of the MPC and, in any case, were intended to safeguard financial stability rather than to alleviate inflationary pressures. It had been expected that alongside the interest rate decision, the CBI would announce a reduction in maximum loan-to-value ratios or other restrictions on mortgage lending, but the above-mentioned statements from the bank’s senior officials make such a move seem less likely.

When questioned, Ásgeir and Rannveig said they were not concerned about breaking the ice by being the first central bank to embark on post-COVID monetary tightening. They noted that Iceland had performed well in terms of mitigating the economic impact of the pandemic and that the CBI had more scope to change interest rates than most other central banks did. Even with this rate hike, the policy rate was still very low and the real policy rate negative by a large margin. The turnaround in the economy had begun, and the authorities’ task was to unwind economic policy support for households and businesses at a pace that would allow the recovery to take root without subsequent overheating.

Macroeconomic forecast relatively upbeat

The CBI’s new macroeconomic forecast, published this morning in Monetary Bulletin, takes a somewhat cheerier tone than its predecessors. GDP growth is forecast at 3.1% this year and 5.2% in 2022. In the CBI’s opinion, the sunnier outlook is due not least to stronger growth in private consumption and exports, both this year and next. On the downside, the bank now projects more sluggish investment growth in the coming term, as well as somewhat stronger growth in imports. It is noteworthy that the CBI expects stronger export growth this year, even though it projects a slower year-on-year increase in tourist arrivals than it did in its February forecast. The main determinant here is stronger growth in other exports, such as marine products, energy-intensive industrial products, and the like.

Moreover, the CBI now forecasts lower unemployment than it did last time. As before, though, the bank expects unemployment to be quite persistent, with registered unemployment averaging 9.1% this year and falling to 6.1% in 2023. When asked about the interaction between this persistent unemployment, on the one hand, and the swift rise in real wages plus robust private consumption growth, on the other, Chief Economist Þórarinn G. Pétursson said it was likely that equilibrium unemployment was higher than it had been before the Corona Crisis and that the labour market was showing signs of imbalances between supply and demand as regards education and specialisation. The Governor also pointed out that the rapid rise in wages in Iceland relative to other economies was unsustainable in the long term. The Deputy Governor added that wage inflation in excess of the inflation target would ultimately lead to higher interest rates.

The CBI’s inflation forecast is considerably more downbeat now than it was at the turn of the year. The bank now expects inflation to average 4.1% this year, as opposed to 3.1% in its last forecast. As before, however, it expects inflation to be close to the bank’s 2.5% target in the latter half of the forecast horizon. The CBI’s inflation forecast is similar to our own most recent one, as we expect inflation to taper off from 4.1% this year to 2.6% in 2022.

Monetary tightening paused until early winter?

We published our take on the outlook for interest rates in coming quarters in our policy rate forecast last week, and today’s events do not change our view. We expect the policy rate to remain unchanged until Q4, followed by a gradual tightening at the rate of 0.25 percentage points per quarter. If our forecast materialises, the policy rate will measure 2.25% by the end of 2022. As always, though, the uncertainty about the policy rate path increases further out the horizon, and the interaction between falling inflation and the narrowing slack in the economy will determine the pace of rate hikes to come.

Analysts


Jón Bjarki Bentsson


Chief economist

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Bergþóra Baldursdóttir


Economist

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