In February, the Committee voted unanimously in favour of Governor Ásgeir Jónsson’s proposed 50-bp rate cut, but it also discussed a 25-point rate cut at that time, as is stated in the minutes of the MPC’s February meeting.

At that time, the Committee observed that the real policy rate had risen since its previous meeting, held in late November. As a result, the MPC was of the view that there was scope to lower nominal rates without pushing the real rate below its end-November level. The MPC also appeared to be broadly in agreement that the monetary stance would have to remain relatively tight in order to bring inflation back to the 2.5% target in the medium term.

The forward guidance in the MPC’s February statement was neutral but cautious:

Although inflation has eased and inflation expectations have fallen, inflation pressures remain, which calls for a continued tight monetary stance and caution regarding decisions going forward. This is compounded by elevated global economic uncertainty.

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

In light of developments since February, we think it most likely that the Committee will consider it safe to lower the policy rate modestly this time. We think a larger rate cut unlikely at present, and actually, Committee members could even rustle up a few arguments in favour of holding the policy rate unchanged, as we explore below.

In reaching its decision, the MPC will probably weigh various factors, including the following:

Arguments in favour of a rate cut:

• Inflation has fallen between decision dates.
• The labour market is showing signs of being better balanced.
• Demand pressures in the housing market are subsiding.
• The real rate is high despite nominal policy rate cuts since the beginning of October.

Arguments in favour of holding the policy rate steady:

• Investment remains solid.
• The outlook for medium-term wage developments has grown more uncertain following the contracts with teachers.
• Inflation expectations and the breakeven inflation rate are stubbornly high.
• Increased optimism among households and businesses could stimulate demand growth in the coming term.

A resilient economy

The Icelandic economy has been quite resilient despite a high real interest rate, persistent inflation, and headwinds in various key export sectors. According to Statistics Iceland’s newly published national accounts for the period through end-2024, GDP grew by 0.5% last year. For comparison, it is worth noting that in the February 2025 issue of Monetary Bulletin, the CBI estimated year-2024 GDP growth at -0.4% in real terms. We concluded more or less the same in our own macroeconomic forecast from January, wherein we projected GDP growth at -0.5% for the year. The CBI is not scheduled to publish another issue of Monetary Bulletin concurrent with this month’s policy rate decision, so its February forecast will presumably provide the underpinning for next week’s decision.

In particular, year-2024 investment growth turned out stronger in SI’s figures than either we or the CBI had expected. Furthermore, the contribution from net trade was rather more favourable than anticipated, despite strong growth in investment goods imports. On the other hand, private consumption growth was somewhat more sluggish than we and the CBI had envisioned. In our opinion, this indicates that households are exercising greater caution and showing a stronger proclivity to save than they sometimes have in the past. It also means that households may have more of a financial cushion they usually do when optimism gains ground and real rates decline – a cushion that they may use to boost consumption spending in the period ahead.

Forward-looking indicators such as the Gallup Consumer Confidence Index (CCI) and the expectations survey conducted (also by Gallup) for the Confederation of Icelandic Employers and the CBI suggest that optimism has grown among the general public and large company CEOs alike. For instance, the CCI has averaged 112.4 points in Q1/2025 to date, suggesting that respondents who are upbeat about the economy and labour market far outnumber those who are pessimistic. In this respect, the CCI is at its highest since end-2021. The CCI, like similar measures of corporate expectations, has bounced back strongly from its mid-2024 trough.

Although the economy is chugging along, there are also widespread signs of greater equilibrium. One example is the labour market, where job vacancies have declined and unemployment has inched steadily upwards. Registered unemployment measured 4.3% in February, its highest in nearly three years. An upward trend in the jobless rate can also be detected in SI’s most recent labour force survey.

On the other hand, the fresh-baked wage agreements with teachers provide for considerably larger pay increases in the years ahead than the private sector contracts made last year. Doubtless, the MPC will note that the risk of wage drift in the coming term has grown as a result, as has uncertainty about how the landscape will look when the bulk of wage agreements expire in early 2028.

Moreover, the housing market showed various signs of being better balanced in H2/2024. Turnover shrank; prices rose far more slowly, on average, than they did earlier in the year; and the recently published HMS measure of buyers’ and sellers’ relative negotiating position indicates a balance between the two groups in late 2024. Nevertheless, the first indications of developments in 2025 suggest that the housing market remains quite resilient. For instance, according to the most recent monthly report from the HMS, the number of properties taken off the market increased markedly between December 2024 and January 2025, and the house price index rose sharply in January.

Inflation is falling, but expectations are still quite high

Disinflation has been broadly as expected in 2025 to date, which will probably come as a relief to MPC members. Headline inflation measured 4.2% in February, or 0.4 percentage points lower than at the time of the MPC’s last meeting, held at the beginning of that month. Measures of underlying inflation declined as well, according to SI’s most recent measurements. This slide in inflation will not come as a shock to CBI officials, however, as the bank itself projected Q1/2025 inflation at 4.2% in its early February forecast.

As before, we expect inflation to keep subsiding until the summer, as large monthly increases will drop out of twelve-month CPI measurements, while at the same time, slower wage growth, falling inflation abroad, and a better balanced housing market should temper the month-on-month rise in the CPI. Nonetheless, we expect the last lap of the race to the CBI’s inflation target to be a difficult one, and we think average inflation is more likely than not to be somewhat above target in the coming term.

Furthermore, recent developments in the breakeven inflation rate in the bond market will probably give the MPC little cause for cheer. In early February it had risen by 0.1-0.2 percentage points since the November 2024 MPC meeting, and market agents’ inflation expectations had done largely the same. On the other hand, households’ and businesses’ inflation expectations had fallen significantly over the same period, and the MPC viewed that as a counterweight to the rise in market expectations.

The Committee will probably not have new inflation expectations data for households, businesses, and market participants at its next meeting, but it will be able to look to the breakeven inflation rate for signs of the past few weeks’ developments in expectations. The picture there is something of a mixed bag.

The short-term breakeven rate has risen markedly. Our calculations suggest that the two-year breakeven rate has risen by 0.22 percentage points and the three-year rate by 0.30 points. On the flip side, the ten-year rate has fallen by 0.10 percentage points and the implied five-year rate five years ahead – which the CBI pays close attention to as a measure of long-term expectations – has fallen by more than 0.3 points. The breakeven rate in the market is higher than is consistent with the inflation target, though, even if it is assumed that part of the deviation is due to an uncertainty premium and a liquidity premium.

Limited scope for a lower real rate at the moment

In early February, the MPC deemed it necessary to maintain a fairly tight monetary stance in the near future, as is noted above. This implies that interest rates must be somewhat higher than inflation and inflation expectations. CBI officials have estimated that the equilibrium real rate could be just over 2% at present. Nevertheless, the real rate must be kept higher than this in the coming term, as inflation and inflation expectations are still above the CBI’s 2.5% target and the economy is not yet showing signs of a slack in output.

Based on the measures shown in the chart, we estimate the current short-term real rate at somewhere between 3.7% and 4.2%. Long-term real rates are around 2.9% in terms of the inflation-indexed Treasury bond yield curve. The real rates offered to households – i.e., rates on indexed mortgage loans – are in the 3.2-5.0% range at present and are still very high relative to the average of the past decade or so.

Based on the comments made by the MPC at the time of its early February interest rate decision and developments since then, we believe there is scope to lower the policy rate slightly without running the risk that the short- and long-term real rate will deviate radically from its recent level. Whether there is room for a significant reduction in the real rate later on will depend on developments in inflation, inflation expectations, and demand pressures in the economy.

Monetary easing set to continue until mid-2026

As we see it, the big picture on interest rates is still the same as the one we sketched out in our macroeconomic forecast from late January. As before, we expect the policy rate to be cut each quarter in 2025 and to reach 6.5% by the year-end. Early in the year, rate cuts will be largely in line with the drop in inflation and, hopefully, in inflation expectations. After mid-year, though, there will probably be scope for slow and steady real rate cuts, even if inflation does not fall steeply in H2 and the years ahead.

If our inflation and macroeconomic forecast is largely borne out, however, there will hardly be space for an exceedingly low real policy rate in the coming term. We therefore project that the CBI’s monetary easing phase will end when the policy rate hits 5.0-5.5%. Rates are unlikely to decline further unless inflation falls to the 2.5% target or below it and remains there for a protracted period, or unless the domestic economy suffers some shock that triggers a setback and a slack in output.

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