We project that the Monetary Policy Committee (MPC) of the Central Bank (CBI) will decide to cut interest rates by 0.5 percentage points on 5 February, its next rate-setting date. Presumably, the Committee will end up choosing whether to lower the policy rate by 0.5 or 0.25 points, and the smaller rate cut is certainly not out of the picture, although we think the bigger step is more likely.
We forecast a 0.5% interest rate cut on 5 February
We forecast that the policy interest rate will be lowered by 0.5 percentage points on 5 February, although a rate cut of 0.25 points is also a possibility. Falling inflation, lower inflation expectations, and signs of more muted demand pressures in the economy are among the main reasons for a rate reduction. The outlook is for the policy rate to keep falling, reaching 6.5% by the end of 2025 and declining somewhat more in 2026.
In reaching its decision, the MPC will probably weigh the following factors:
Factors in favour of a larger reduction:
- Inflation has fallen between decision dates.
- Inflation expectations are lower, short-term expectations in particular.
- The labour market is showing signs of being better balanced.
- Demand pressures in the housing market are subsiding.
- The real interest rate has remained high despite nominal policy rate cuts in recent months.
Factors in favour of a smaller reduction:
- There are signs that demand could gain momentum in the near future.
- Indicators imply that the economy is still quite resilient.
- There is uncertainty about imminent teachers’ strikes and the potential impact of ensuing wage agreements on the fiscal stance and subsequent developments in the labour market.
- If interest rates are lowered too quickly, it could erode the credibility of monetary policy.
- There are only six weeks between the February interest rate decision date and the following one, in the second half of March.
In November, the MPC voted unanimously to lower the policy rate by 0.5 percentage points. At that time, it was noted that the Committee’s next regularly scheduled meeting would not take place until 2025, and members considered that there was scope to implement a larger rate reduction while still maintaining a monetary stance that would support continued disinflation and a narrower output gap in the coming term. Even so, it looked as though it would still be necessary to maintain a tight monetary stance.
Growing momentum in the economy
In our most recent macroeconomic forecast, we review the current situation and prospects for the Icelandic economy. We estimate the year-2024 contraction in GDP at 0.5% in real terms. While this is a mild contraction in most senses of the term, it marks a turn in the business cycle. However, domestic demand grew modestly in 2024, although in our assessment, the negative contribution from inventory changes due to the failed capelin catch weighed somewhat more heavily.
We forecast GDP growth for 2025 at 2.2%, driven mainly by growing consumption, private consumption in particular, which in turn is due to more rapid growth in real wages and population, plus drawdowns of accumulated savings. A positive contribution from net trade also contributes to growth.
In the latter two years of the forecast horizon, the outlook is for output growth to pick up a bit more, to 2.5% in 2026 and 2.6% in 2027. The main catalyst of brisker growth is a rebound in investment alongside lower interest rates and a stronger investment need in the export sector. According to our forecast, private consumption growth will soften marginally at the same time.
To summarise, the outlook is for GDP growth to pick up steadily in the coming term, and it looks as though there will not be a significant slack in the economy over the next three years or so. As a result, there are limits – if the forecast materialises – on how much real interest rates can fall before the monetary stance starts fuelling output growth in excess of capacity in coming years.
The inflation outlook and inflation expectations
According to Statistics Iceland’s (SI) newly released CPI measurement, inflation measured 4.6% in January. It has therefore fallen by half a percentage point since the MPC’s November decision. The outlook is for continued disinflation in coming months, and our preliminary forecast assumes that inflation will be down to 3.5% by April.
Our macroeconomic forecast discusses the inflation outlook for the coming term. For 2025 as a whole, we expect inflation to average 3.6%. More stable prices abroad, limited wage drift, and a stable ISK will do the most to keep it at bay. For 2026, we expect it to average 3.0%, but we do not envision a further decline. In 2027, we expect an average inflation rate of 3.2%.
The biggest short-term uncertainty centres on wage agreements for the labour market segments whose contracts are still outstanding. Furthermore, there is general uncertainty about changes in government leadership, both in Iceland and abroad. Moreover, developments in the housing market will affect the pace of inflation in coming quarters.
According to our forecast, inflation will not return to target during the forecast horizon; however, it will fall below the upper tolerance limit in March. We expect it to move very close to target by mid-year, but if this is to materialise, the exchange rate needs to be fairly stable and wage drift limited.
The MPC pays close attention to inflation expectations in its assessment of the necessary monetary stance. Since winter began, expectations have fallen by nearly all measures. In particular, households’ and businesses’ inflation expectations for the remainder of the 2020s have improved, as the chart indicates.
The newly published market expectations survey results suggest a bit of a setback, however. According to the median response, market participants’ five-year inflation expectations inched up from 3.3% to 3.4% between measurements, and their ten-year expectations rose from 3.0% to 3.4%. Even so, both figures are lower than they were this past autumn.
It is noteworthy that at the same time, this same group’s expectations about developments in the policy rate and average rates on 10-year Treasury bonds appear to be unchanged, and the implied breakeven inflation rate in terms of expectations about 10-year indexed and non-indexed base rates over the next five years has actually declined between surveys. As a result, it is probably wise to avoid overinterpreting the results of the survey, although the MPC will certainly consider them.
Real rates are high
Even though the nominal policy rate has been cut by 0.75 percentage points since the beginning of October, real interest rates have hardly budged and are still quite high by most measures, if not all of them. This reflects developments in inflation and inflation expectations, which have generally kept pace with policy rate cuts and, by some measures, fallen further.
By the measures we use, short-term real rates lie in the 3.7-4.3% range, as the chart shows. Long-term real rates are around 2.7% for 10-year Treasury bonds. Furthermore, inflation-indexed mortgage lending rates are at their highest in over a decade. Thus there is scope to lower the policy rate without unduly loosening the monetary stance relative to its position before the CBI began unwinding it last autumn.
Continued policy rate cuts well into 2026
Since the MPC’s November decision, inflation expectations have fallen by most measures, although the breakeven rate and market agents’ long-term expectations have moved upwards in recent weeks. Furthermore, indicators imply that the output gap is narrowing, price pressures in the housing market are easing, and wage costs are rising more slowly. On the other hand, growing private sector optimism and accumulated savings suggest that domestic demand will be resilient. In addition, unemployment is still low and the labour participation rate high.
If our projections of developments in inflation and economic activity are borne out, the CBI’s monetary easing episode will probably continue largely unabated until mid-2026 or so. Nevertheless, some hiccups can be expected along the way, with temporary fluctuations in inflation or the short-term economic outlook.
As a result, we forecast that the policy rate will be 6.5% at the end of 2025. The outlook is for the easing phase to end when the policy rate hits 5.0-5.5% after mid-2026. The policy rate will hardly be lowered further unless the economy suffers a setback and/or inflation develops even more favourably than we anticipate.
Analyst
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