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Was the Central Bank in the monetary tightening vanguard?

Among the options discussed by the Central Bank’s (CBI) Monetary Policy Committee (MPC) in October was the possibility of keeping interest rates unchanged. In the end, the Committee agreed unanimously to raise rates by 0.25 percentage points and issue much milder forward guidance than before. The CBI looks set to be among the first central banks to bring post-pandemic monetary tightening to a close.

All MPC members agreed to raise the CBI’s policy rate by 0.25 percentage points on 5 October. It was the first time since May that all members voted unequivocally in favour of the Governor’s proposal. In both June and August, Gylfi Zoëga would have preferred a larger rate hike, but in both instances he acceded to Governor Ásgeir Jónsson’s proposal to raise the policy rate by 1 percentage point (in June) and 0.75 percentage points (in August).

This is included in the minutes from the MPC’s October meeting, published yesterday on the CBI website.

According to the minutes, MPC members were of the opinion that there were grounds to either hold the key rate unchanged or raise it by 0.25-0.5 percentage points. The former piqued our interest, as the tone in the August interest rate decisions was unambiguously in favour of a rate hike.

The MPC’s main arguments in favour of leaving the policy rate unchanged were as follows:

  • Inflation had been lower than expected in the recent term.
  • The short-term inflation outlook had improved.
  • Inflation expectations had fallen by some measures.
  • The Bank’s real rate had therefore risen between meetings and looked set to rise further if inflation continued to fall.
  • Clear signs had emerged to indicate that the Bank’s actions had begun to affect demand, as housing market activity and house price inflation had started to ease.
  • Tensions in the labour market also appeared to have eased in the recent term.
  • Furthermore, private consumption growth could be expected to lose pace, all else being equal, as real wages had begun to contract.
  • The global economic outlook was worse than expected, particularly in view of the rising cost of living in Europe and the troubled outlook for energy supply, which could have a detrimental impact on the outlook for Iceland’s exports.

The MPC’s key arguments for a rate hike were these:

  • Although inflation had fallen between meetings, it was still far above the target.
  • Underlying inflation had risen.
  • Long-term inflation expectations were above the target.
  • The inflation outlook in trading partner countries had deteriorated, and there was the risk that second-round effects on domestic inflation would increase accordingly if firms passed higher input costs through to domestic prices.
  • Annual wage inflation had been strong for some time, and in the MPC’s opinion, the labour market was still tight and domestic demand strong.
  • As a result, the monetary stance was not tight enough given the business cycle position and the output gap, as the Bank’s real rate was still negative and below its equilibrium level.
  • It was important to avoid easing the policy stance too soon, as this could make bringing inflation down costlier than it would be otherwise.

To refresh readers’ memory, the forward guidance from the MPC’s October decision states as follows:

The MPC will continue to ensure that the monetary stance is tight enough to bring inflation back to target within an acceptable time frame. Near-term monetary policy decisions will depend on developments in economic activity, inflation, and inflation expectations. Decisions taken at the corporate level, in the labour market, and in public sector finances will be a major determinant of developments in interest rates in the coming term.

This is a far mellower tone than the MPC has taken thus far in 2022, and it can even be said that the Committee’s forward guidance has shifted into neutral from the clear monetary tightening message earlier in the year.

Quicker on the uptake than most

The last policy rate decision of the year is scheduled for 23 November. We expect the MPC to hold the policy rate unchanged at 5.75% at that meeting, and we think it highly likely that the October rate hike represents the end of this monetary tightening phase.

The CBI’s recent responses to developments in inflation and the economic outlook have drawn considerable attention abroad. For example, the Governor was recently crowned Head of the Class by financial website Global Finance, earning a grade of A+ for the best monetary policy performance of the year, the only central banker in the world to achieve the top ranking. As is well known, many leading central banks have faced growing criticism for their tardy response to rising inflation in the recent term, and some are in the unenviable position of feeling forced to raise rates higher in response to persistent inflation at a time when the global economic outlook has soured materially.

In any event, the CBI was among the first central banks to start raising rates from their historical low during the worst of the pandemic. By the same token, the CBI may turn out to be among the first to call a halt to monetary tightening. To the best of our knowledge, the Hungarian National Bank is the only central bank in our part of the world to have stated outright that it will not raise rates further. As the chart indicates, the slope of Hungary’s tightening phase is far steeper than Iceland’s is. Virtually all other leading central banks seem to be continuing on the rate hike path.

Our updated policy rate forecast assumes that the CBI will not raise rates further in the near future. We project that the policy rate will remain steady at 5.75% until mid-2023 and then begin a slow and steady decline as inflation eases and the domestic economic rebalances.


Jón Bjarki Bentsson

Chief economist