In early February, the MPC decided to keep the policy rate unchanged at 9.25%, where it had been since the end of August 2023. One member – Gunnar Jakobsson, Deputy Governor for Financial Stability – voted against the proposal, however, as he preferred to lower interest rates by 0.25 percentage points.

According to the minutes of the MPC’s February meeting, the main arguments in favour of an unchanged policy rate were as follows:

• Inflation remained high and the inflation outlook had improved primarily for 2024, while the longer-term outlook had improved only marginally.
• Because the labour market was still quite tight, unit labour costs could rise more than they would otherwise.
• There was significant uncertainty about the outcome of wage negotiations.
• Government measures relating to wage agreements and the situation in Grindavík created uncertainty about the fiscal stance, as it was unclear how the measures would be financed.
• Although domestic economic activity had eased, there was still the risk that firms would to some extent pass cost increases through to prices in the wake of the forthcoming wage settlements.
• Housing market activity appeared to be picking up again, and house prices had risen in the recent term.
• Long-term inflation expectations had held broadly unchanged, even though growth in domestic demand had lost pace and the inflation outlook had improved.
• It was important to bring inflation expectations down in order to ensure that inflation would realign with the target.
• In view of the high level of uncertainty, it was not a given that the monetary tightening phase was at an end, and because demand pressures still remained in the economy, it would be better to keep interest rates high for longer than to lower them too soon.

The main arguments for a rate cut were these:

• The most recent data showed that the monetary stance had been sufficient in the recent past, as economic activity had subsided steadily.
• Recent developments in the economy, the inflation outlook, and the real rate suggested that the time had come to lower the policy rate.
• The Central Bank’s real rate was at its highest since 2012, and all indicators implied that it would rise considerably more in coming months.
• The risk existed that the real rate would rise more than necessary at a time of rapidly declining growth in economic activity.

Below is a summary of various points that we expect the MPC to consider in connection with the March interest rate decision:

The economy is cooling …

It is safe to say that the Icelandic economy shifted gears last year, as we have discussed recently. According to preliminary figures from Statistics Iceland, GDP grew by 0.6% in Q4/2023, the weakest growth rate since the post-COVID recovery started in spring 2021. Private consumption, investment, and services exports contracted year-on-year during the quarter, and the fact that output growth was positive at all was thanks only to an even larger contraction in imports, plus modest growth in goods exports and public consumption.

National expenditure, which mainly comprises the sum of consumption and investment and is a reflection of domestic demand, contracted in H2/2023, after a period of robust growth lasting from Q4/2021 until Q1/2023. Furthermore, growth in services exports lost steam over the course of the year.

Recent indicators such as payment card turnover, imports, expectations surveys, international travel, and new motor vehicle registrations suggest that the economy is still cooling after the upswing of 2021-2022. Furthermore, the labour market looks set to ease slowly and steadily, as we have discussed in the recent past.

Moreover, uncertainty about export growth in 2024 has been mounting in recent months, although, and at the end of January we projected that year-2024 GDP growth would measure 1.9%, driven largely by export growth. The more ambiguous outlook for this year’s exports can be traced to two factors:

• This year’s capelin fishing season is unlikely to generate significant foreign exchange revenues, after recent surveys of stock sizes in Iceland’s territorial waters gave negative results. V
• Prospects for growth in tourism this year have grown much cloudier. Various tourism operators have voiced concerns about the status of bookings, not least because demand for travel to Iceland has been affected – directly and indirectly – by the volcanic activity on the Reykjanes peninsula. If growth in tourism is weak or flat in 2024, the labour market will soften and demand pressures in the housing market will ease, among other factors.

… and the outlook is for falling inflation in the coming term

February inflation figures were disappointing to us – and probably to most other observers as well – after the steep decline in January. Nevertheless, it is worth noting that underlying measures of inflation showed a continued decline in February, and it is likely that some of the 1.3% rise in the CPI during the month will be offset by a smaller increase in March. In its most recent Monetary Bulletin, the CBI forecast that inflation would measure 6.3% in Q1/2024. Now, however, it looks as though that forecast was overly optimistic and that inflation will be around 6.6% in Q1.

Even so, we think the big picture – that headline inflation is set to fall quite quickly in coming quarters – is unchanged. Of no small importance in this regard is the recent signing of wage agreements by member organisations of the Icelandic Federation of Labour, on the one hand, and of the Confederation of Icelandic Employers, on the other. We consider the wage provisions in the contracts to be broadly conducive to price stability, in that wages move in line with the Central Banks inflation target plus labour productivity. Furthermore, the contracts have a term of four years, and it is fairly unlikely that the clauses about inflation in coming years will be triggered and force a wage level review.

Although it is still uncertain whether, and to what extent, the Government’s involvement in the labour market agreements will cause the fiscal stance to ease more in coming years than it would have otherwise, the fresh-baked contracts seem to indicate that wages in Iceland could align more closely with the inflation target than they have in recent years. As a result, we think MPC members are more likely than not to view the wage contracts as a factor in favour of a policy rate cut.

Inflation expectations a thorn in the side of the MPC

Persistently high inflation expectations have justifiably been a burr in the MPC’s saddle in recent quarters. Concerns about inflation expectations have weighed heavily in the Committee’s recent decisions and are probably the main argument against cutting the policy rate now. After several years of expectations in line with the CBI’s inflation target, the link between the two was severely stretched by the inflation episode at the beginning of the 2020s, which pushed expectations rapidly upwards and has kept them high by all measures, as the chart indicates. For instance, market agents expect inflation to average 4.1% over the next five years and 3.8% over the next ten years, according to the median response in the CBI’s last market expectations survey, taken in late January. Households and businesses were even more pessimistic about the five-year inflation outlook as of late 2023.

The breakeven inflation rate in the bond market has also been well above the 2.5% inflation target in the recent term, although it has tapered off since last autumn, concurrent with the decline in inflation. A key metric taken into account by CBI officials is the five-year breakeven rate five years ahead. With some simplification, it can be said that the so-called 5y-5y breakeven rate gives an idea of the expected inflation rate during the period from 2029 through 2033.

The 5y-5y breakeven rate peaked at 4.1% in late November 2023. Based on the most recent figures from the bond market, it is now 3.4%, however. While this is still nearly a percentage point above the CBI’s inflation target, it is worth considering that the breakeven rate includes an uncertainty premium, as today’s investors can lock in real returns of approximately 2.5% over ten years’ time by buying indexed Treasury bonds, while there is some risk that a corresponding nominal Treasury bond would deliver lower returns. Risk-averse investors will therefore want some compensation for assuming that risk, and this compensation comes on top of the spread between indexed and non-indexed interest rates, which reflect market agents’ average expectations of long-term inflation. With a pinch of optimism, it is possible to say that the long-term breakeven rate does not necessarily reflect expectations that long-term inflation will be far above the CBI’s 2.5% target.

Real interest rates have risen

As Gunnar Jakobsson pointed out during the MPC’s February meeting, the real rate has risen markedly by all measures in recent quarters. For instance, the real policy rate in terms of the average of forward-looking measures of inflation was -1.8% in mid-2022 but had risen to +2.9% by the end of 2023. Comparing the policy rate to past inflation gives a similar result: the real policy rate was around -3.8% in mid-2022 and +2.5% in February 2024. Long-term real rates have developed similarly. For instance, the yield on an indexed Treasury bond with a ten-year duration has risen from just under 1.0% in mid-2022 to almost 2.6% in March 2024 to date.

Based on our inflation forecast for the next several quarters, the real rate will continue to rise relative to past inflation, all else being equal, even if the policy rate is lowered in the near future. It is more difficult to predict developments in the real policy rate further ahead, but the experience of recent years has shown that long-term inflation expectations have increasingly moved in line with short-term developments in inflation, as the CBI discussed recently in Monetary Bulletin. As a result, interest rate policy could also remain tight by this measure if long-term expectations decline in the wake of falling inflation in the near future, even though the policy rate eases at the same time.

Interest rates set to decline in the coming term

As is noted above, it is not crystal-clear whether the MPC will lower the policy rate in March, although we think this is the right time to start easing the monetary stance. If the Committee does not lower rates this month, the second-likeliest scenario is that monetary easing will start in May, by which time the cooling economy and receding inflationary pressures should have become even clearer. The CBI will doubtless begin lowering rates gradually, given that inflation expectations are still high and the slack in the economy is not yet significant.

We expect the policy rate to be lowered by 1.5 percentage points in 2024, to 7.75% at the year-end. For 2025, we expect further rate cuts totalling 2.25 percentage points, possibly bringing the policy rate down to 5.5% at mid-year. Whether and how much the policy rate declines thereafter will depend on how quickly the economy rebounds from the current slowdown, and whether inflation falls back to the target.

Although it is still far too soon the celebrate victory in the battle against high inflation and interest rates, recent developments suggest to us that the outcome is likelier than not to be favourable. If inflation falls back to target in coming years and GDP growth is close to potential output at the same time, we estimate the equilibrium policy rate at 4.0-4.5%. Whether the MPC lowers the policy rate to this level will depend on factors such as the results of the still-outstanding wage negotiations, the balance in the housing market, and the stability of the ISK.