The MPC held interest rates unchanged for the second time in a row in October, after a spate of rate cuts stretching from October 2024 until this May. Committee members voted unanimously in favour of the decision, as they had in August. The forward guidance from October was similar in tone to that from August, albeit slightly more accommodative. It reads as follows:

Many factors have moved in the right direction, but the conditions that would enable an easing of the real interest rate have not yet emerged. Further interest rate cuts will depend on whether inflation moves closer to the Bank’s 2½% target.

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

In other words, the MPC continued to make its next policy decisions contingent upon a decline in twelve-month inflation, as it has done since May. We were actually sorry not to see a reminder that interest rates may need to rise again if inflation develops unfavourably, but any doubts on that score were put to rest at the press conference following the announcement.

Although forward guidance of this type is certainly clear and concise, it has the drawback of focusing on historical developments rather than looking ahead at the economic and inflation outlook. For instance, we have pointed out that if the economic outlook should change materially without a change in the pace of inflation, the MPC would find itself in a tight spot. It appears that just such a tight spot is developing now.

Below is a summary of the factors that will probably weigh heaviest in MPC members’ minds at the upcoming meeting.

The domestic economy is sailing close to the wind

There is no doubt that the economy is cooling, and at a brisk pace. Although domestic demand is more robust at present than Statistics Iceland’s (SI) estimate of 0.3% GDP growth in H1/2025 would suggest, signs of waning tensions or growing slack are widespread. For instance, job growth has slowed decisively, and the number of firms that consider themselves short-staffed has tumbled. At the same time, population growth has tapered off, largely because of reduced net inward migration. Unemployment has inched upwards and will probably be higher this winter than it was a year ago.

Furthermore, households’ and businesses’ expectations about the economic outlook have grown significantly bleaker in recent measurements, although on balance, both groups’ financial conditions still appear quite good. Payment card turnover, the frequency of overseas travel, and new motor vehicle registrations suggest a sizeable increase in household consumption in Q3, on the heels of nearly 3% growth in H1. For example, payment card turnover grew by just over 4% year-on-year at constant prices in Q3, and Icelanders’ departures via Keflavík Airport were up 11% YoY at the same time. New motor vehicle registrations to individuals were up 48% in the first three quarters of 2025, after contracting sharply in 2024.

The past few weeks have seen a torrent of bad news for Iceland’s export sectors, as we have reported recently. The outlook is for a contraction in exports of both marine products and manufactured goods from the energy-intensive sector in 2026. Furthermore, it is highly uncertain whether demand for travel to Iceland will hold its ground later this winter and whether it will grow or contract during next year’s peak tourist season. Newly published data on departures from Keflavík Airport in October 2025 reflect a 6% YoY downturn in foreign nationals’ departures after this summer’s impressive surge. The outlook for year-2026 GDP growth has therefore darkened considerably since we published our macroeconomic forecast in September, and by the same token, the slack in the economy looks set be larger and the labour and housing markets less robust than would otherwise be the case.

The CBI will publish a new inflation forecast in Monetary Bulletin on 19 November, concurrent with the upcoming interest rate decision. In that forecast, the bank will undoubtedly sketch out a decidedly bleaker picture of next year’s economic developments than we saw in the August forecast, which assumed a GDP growth rate of just over 2% in 2026. The poorer outlook will surely draw considerable attention from the MPC during the decision-making process and, in all likelihood, will provide the strongest grounds for a policy rate cut.

But it should be borne in mind that the CBI – unlike, say, the US Federal Reserve – has no other monetary policy mandate than keeping inflation as close to target as possible. As long as financial stability and the security of domestic financial activities are not under threat, the battle against inflation takes priority. MPC members have therefore declared themselves willing to force the economy into a hard landing if that is the only way to attain the 2.5% inflation target. In our assessment, as long as inflation itself remains stubborn and inflation expectations are out of sync with the target, it would not boost monetary policy credibility if the Committee were to respond to a poorer economic outlook by lowering interest rates now, after issuing the forward guidance we have seen in the past half-year.

Inflation has proven tough to dislodge

The fight against inflation has certainly proven to be a longer and tougher battle than most had hoped, ourselves included. Headline inflation now measures 4.3%, nearly 2 percentage points above the CBI’s target and above the upper tolerance limit as well. Actually, inflation has been more or less rooted at around 4% for virtually all of this year, apart from a few isolated monthly swings.

Another cause for concern is that many inflation metrics other than the CPI have been on the rise rather than falling in recent months. For instance, the CBI Governor has noted concurrent with recent policy rate decisions that inflation in terms of the CPI excluding housing (CPIXH) was virtually at target. But CPIXH inflation is now 3.3%, its highest since August 2024, and has risen by half a percentage point in the past two months. The same can be said of inflation according to the Harmonised Index of Consumer Prices (HICP) and SI’s core indices. By all of these measures, inflation has picked up in the past twelve months, and as the chart shows, none of them can considered aligned with the target at present.

In our response to October’s inflation figures, we published a preliminary forecast for the months ahead, which states that inflation will probably hover just above 4% through the year-end and finally start to ease towards the end of winter. In that forecast, we project headline inflation at 3.3% in mid-2026, followed by a period with average inflation ranging from 3.5% to 3.7%.

In August, the CBI forecast that inflation would measure 4.5% in Q4/2025 and then taper off steadily. It projected that inflation would measure 3.0% in Q4/2026 and then return to target in mid-2027.

It is worth noting that the CBI’s forecasts have changed somewhat in recent quarters. From May 2024 until early February 2025, the bank projected that inflation would reach the target in Q3/2026. In its last two forecasts, however, realignment with the target was shifted back in time to Q2/2027. In retrospect, it is interesting that the MPC should have lowered the policy rate in May, even though the inflation outlook had changed slightly for the worse.

Inflation expectations still high

In forward-looking monetary policy, expectations about medium-term developments in inflation are a key factor in decisions on the monetary stance. When considering this medium-term scenario, the MPC looks at two types of measures of inflation expectations: on the one hand, the so-called breakeven inflation rate, which represents the difference between indexed and non-indexed Treasury bond yields in the bond market, and on the other hand, the results of expectations surveys taken from the general public, executives from large companies, and financial market participants.

Breakeven inflation rates in the market have diverged somewhat since the last interest rate decision. For instance, the short-term breakeven rate has risen a bit, the five-year rate has held virtually still, and the ten-year rate has fallen by about 0.2 percentage points. This has caused the five-year rate five years ahead, a metric that CBI officials take seriously as a measure of long-term inflation expectations, has fallen by more than 0.4 percentage points, according to our calculations. That will presumably be good news for the MPC. Nevertheless, it is worth noting that by this measure, the long-term breakeven rate is still 3.8%, well above the inflation target, even if adjusted for the fact that the breakeven rate includes a premium to compensate for uncertainty about real returns on non-indexed long-term Treasury debt.

No new measurements of households’ and businesses’ inflation expectations will be available when the MPC meets next week. The last ones, taken in September, showed that five-year inflation expectations had remained unchanged since the previous survey. According to the median responses, households’ expectations measured 4.0% and business’ expectations 3.5%.

This morning, however, the CBI published the results of its survey of market agents’ inflation expectations, which showed that respondents expect inflation to average 3,0% over the next five years and 3.0% over the next ten. These expectations are unchanged from the last survey in August.

The real rate is high by most measures

The MPC has made frequent references to the real policy rate in recent decisions and press conferences. The Committee has often stated that a real policy rate of 3.5-4.0% reflected a monetary stance that that would be sufficient to bring inflation to target in the coming term.

In recent months, the real policy rate in terms of past inflation has fallen steadily as inflation has risen, reaching approximately 3.1% in October, according to our calculations. By that measure, the monetary stance is at its most accommodative since August 2024. But in terms of inflation expectations – a more logical yardstick of the monetary stance – the real policy rate has held fairly stable at around 3.5%.

The long-term real rate in the bond market has done something of an about-face as well. The rate on 10-year indexed Treasury debt has fallen from 3.1% in August to 2.7% in November to date. Presumably, such a decline in the long-term real rate is a consequence of the worsening near-term economic outlook.

A policy rate cut to ring in the New Year?

Given the darkening economic outlook, it can be argued that inflation can be brought back to target without such a high real rate. But this is complicated by the MPC’s recent forward guidance and its unqualified insistence that there is no room for policy rate cuts until and unless headline inflation gives way. An example of this can be found in the minutes from the Committee’s October meeting (our boldface):

“Because of the strong correlation between inflation expectations and current inflation, the Committee considered it vital to see a clearer drop in inflation before cutting interest rates further. There was a risk that prolonged high inflation expectations would increase the likelihood that wage increases would lead to more persistent inflation than would otherwise occur.”

Such an explicit message dating from just over a month ago leaves the MPC little scope to change tack as regards the need for a tight stance despite the poorer short-term outlook, particularly because SI’s most recent measurements suggest that, in most senses, inflation has been inching upwards.

On the other hand, we think it likely that the MPC will signal that it may start unwinding interest rates soon, even if inflation has not declined by that time. In this context, it is difficult to look past the obvious signs of cooling in the housing and labour markets and the cloudy economic outlook.

In our opinion, it is quite likely that policy rate cuts will start with the first interest rate decision of 2026, scheduled for early February. We assume that the policy rate will be lowered by half a percentage point in Q1/2026 and another 0.75 percentage points in Q2. By the end of Q3, it could be down to 5.5-6.0%. Whether it is lowered further will depend on inflation itself and whether it takes that final lap back to the target. If our forecast of inflation averaging just over 3% in the next few years is borne out, further policy rate cuts are quite unlikely.