We forecast an unchanged policy rate on 22 November

We project that the Central Bank (CBI) Monetary Policy Committee (MPC) will decide to hold the policy interest rate unchanged on 22 November, its next decision date. It is highly likely that uncertainty or adverse effects from the seismic activity on the Reykjanes peninsula will outweigh conventional assessments of economic activity and the inflation outlook. By the same token, interest rate developments in coming quarters will depend both on how matters unfold in the Reykjanes area and how hard monetary policy bites over the course of the winter.

We project that the Central Bank of Iceland (CBI) Monetary Policy Committee (MPC) will decide to hold the bank’s policy interest rate unchanged at 9.25% on 22 November, its next decision date. Developments in the seismic activity on the Reykjanes peninsula could overshadow the conventional status check on the domestic economy, inflation movements, and the inflation outlook. If it comes clear before the interest rate decision that a potential volcanic eruption is unlikely to cause substantial damage to the economy in the near future, an increase of 0.25 percentage points is not out of the question, but as is stated above, we think an unchanged policy rate is the likeliest outcome.

Reykjanes in the crosshairs

As of this writing, there is still considerable uncertainty about how the geological situation in the Reykjanes area will play out. Developments from now until the decision date will presumably be a major factor in the decision itself. Notably, the MPC has said not a word, to our knowledge, about previous eruptions during the current spate of seismic activity. But that could change now, unless the outlook shifts radically in the next few days.

Naturally, we are not geologists, and as a result, we rely on scenarios that experts in the field have provided to the media and outlined in recent press conferences. Briefly, we envision three possible scenarios for the MPC’s decision, based on how matters develop on Reykjanes from now until the decision date:

  • Continued uncertainty about developments on the Reykjanes peninsula: There are strong grounds for taking a wait-and-see approach, leaving the policy rate unchanged and awaiting further developments between this month and the next decision date, in early February 2024.
  • The probability of an eruption has diminished significantly, or an eruption has begun but is expected to have limited impact on transportation, infrastructure, and the economy: The policy rate decision would depend on other factors, and the assessment would be similar to that before the earthquakes began, which is discussed more fully below.
  • A volcanic eruption has begun, with major impact on transportation, infrastructure, and/or the economy (at least two of these): The policy rate would be kept unchanged and the possibility introduced of a rate cut in the near future if the economic setback is likely to be significant.

Divided opinion in October

At the beginning of October, the MPC decided to hold the policy rate unchanged, after 14 successive rate hikes dating back to spring 2021. Committee members were split in their opinions on the decision, however. The in-house members (CBI Governor Ásgeir Jónsson and Deputy Governors Rannveig Sigurðardóttir and Gunnar Jakobsson) agreed that interest rates should be left alone. But the two newest members, who are also the MPC’s external members, were unconvinced about keeping rates unchanged.

  • Ásgerður Ósk Pétursdóttir actually voted in favour of the proposal to keep rates unchanged but would have preferred a 25-bp rate hike.
  • Herdís Steingrímsdóttir voted against the proposal, voting for a 25-bp rate hike instead.

Herdís was of the opinion that indicators of a slowdown in economic activity were not convincing enough. She emphasised that demand pressures in the labour market remained strong and that even though the monetary stance had tightened and the real rate had recently turned positive, she was concerned that the policy stance was not sufficient to bring inflation back to target within an acceptable time frame.

Ásgerður concurred with these views but nevertheless thought it was possible to wait and see, as the MPC’s next meeting would take place soon and the Bank’s new macroeconomic forecast would then be available.

Committee members agreed that the impact of policy rate hikes had started to come more clearly to the fore, but they noted, on the other hand, that the labour market and the economy as a whole remained relatively tight. Indicators implied that domestic economic activity had begun to ease by some measures, but that by other measures it had increased. Given that the overall situation had not changed appreciably since the last meeting, it could be appropriate to wait and see, as the Bank’s new macroeconomic and inflation forecast would be available by the time of the Committee’s next meeting.

The key arguments for an unchanged policy rate in October were as follows:

  • Growth in economic activity had eased and indicators implied more clearly than before that private consumption growth had tapered off as well.
  • Although inflation was still high, it had subsided since the spring, and price increases had lost pace recently.
  • Underlying inflation in terms of the average of various measures had also declined marginally since the Committee’s August meeting.
  • MPC members were of the view that the strategy decided upon in the spring – to raise interest rates steeply so as to get results sooner – had borne fruit, as rising real rates boosted household savings.
  • The effects of higher real rates would also show more clearly in the near future.
  • Monetary policy transmission had been successful, and deposit and lending rates had increased in the recent term.
  • The real rates available to companies were somewhat higher than real rates in terms of the average of various measures, and it could be assumed that under current circumstances, the monetary stance was now sufficient by that measure.
  • It was likely that the monetary stance would tighten further in the coming term as inflation declined; therefore, it was not a given that a further increase in nominal interest rates was needed.

The main arguments for a rate hike were these:

  • The labour market was still tight, and indicators of reduced economic activity were still weak.
  • According to preliminary national accounts figures, the output gap appeared to have been wider in 2022 and H1/2023 than was anticipated at the last MPC meeting, perhaps necessitating higher interest rates.
  • There was greater risk in tightening the monetary stance too little than in tightening it too much, as real rates had only recently turned positive and little would be needed to push them lower once again.
  • There were few indications as yet that the monetary stance was too tight, and there was risk associated with ending the tightening phase too soon.
  • There were concerns that inflation expectations had become less firmly anchored, which could mean that the monetary stance would have to be that much tighter.
  • The ISK had depreciated recently, which could give cause for concern if imported inflation should rise more than it might otherwise.
  • There was a strong likelihood of second-round effects of cost increases on the price level.

Below is an overview of factors we expect the MPC to take into account as they consider next week’s interest rate decision, that is if developments in Reykjanesskagi do not overshadow other concerns at that time:

The economy is cooling … or is it?

Recent statistics give a somewhat ambiguous picture of economic developments in the past few weeks and months. That said, many of them suggest that demand growth will lose considerable steam in the near future. For instance, the Gallup Consumer Confidence Index value for October was its lowest since year-end 2020. Icelanders’ payment card turnover has contracted in real terms recently. Our model, which is based on a principal component analysis in the assessment of private consumption, suggests that private consumption growth measured 2.5-3.0% in Q3 and was therefore well in line with the H1 level of 2.6%. In comparison, private consumption – the most prominent subcomponent in Statistics Iceland’s expenditure accounts – grew in real terms by 8.5% in 2022. At the same time, household saving has gained pace, and tighter monetary policy appears to have been quite effective via that channel in the recent term.

Recent figures on imports of investment goods suggest that investment activity remains strong. Furthermore, according to the results of the September survey of executives from Iceland’s largest companies, respondents are somewhat more upbeat, both about the current situation and outlook and about their own investment plans. That relative optimism could give way, however, with the deprecation of the ISK, increased geopolitical tension due to the war in the Middle East, and the seismic unrest on Iceland’s Reykjanes peninsula. It will be interesting to see the next measurements of corporate expectations, which will be published towards the end of the year.

On the other hand, goods trade figures overall suggest that the economy is cooling. In exchange rate-adjusted terms, goods imports and exports have both contracted markedly year-on-year, after buoyant growth in 2021-2022. Although movements in foreign prices are a factor, we still think this indicates that the economy is at a turning point. Developments in imports suggest that growth in consumption and investment has subsided, while developments in exports indicate that exported goods volumes have stagnated after having grown somewhat in the past two years.

Persistent inflation expected in the near term

Inflation has been more persistent in H2/2023 than previously hoped, after tapering off rather quickly in Q2. In part, though, this was to be expected, as prices fell at the same time in 2022. In its August forecast, the CBI projected that inflation would average 7.5% in Q4/2023. According to our own forecast, however, it looks set to be around 8.0% during the quarter. Similarly, the CBI’s forecast of 4.6% average inflation in 2024 appears a bit more optimistic than our forecast of 5.7% for the year. Most likely, the CBI’s new inflation forecast, due for publication next week, will be more pessimistic about coming quarters than the August forecast was, and it may prove a determining factor in the upcoming interest rate decision.

Furthermore, the ISK has weakened significantly since the October interest rate decision, which should be a thorn in the MPC’s side, all else being equal. On the other hand, that weakening is due largely to a more ambiguous outlook for FX flows in coming months rather than to changes in fundamentals. As a result, the ISK is likely to do one of two things in the next few months:

  • It will continue to sag due to seismic activity on the Reykjanes peninsula. If the ISK does weaken, it will probably be linked to a deteriorating economic outlook; therefore, it would not necessarily call for a targeted monetary policy response apart from perhaps a temporary FX market intervention scheme like that undertaken at the beginning of the pandemic.
  • The Reykjanes situation improves in coming weeks. Because other underlying factors should support the currency over time, as was the case early this year, the ISK would be more likely to rebound to its previous level.

Expectations have moved in the right direction

The results of inflation expectations surveys among households and executives from large companies were a source of considerable relief to the MPC in October. These surveys suggest that respondents’ medium-term inflation expectations have improved somewhat. Corporate executives expect inflation to average 4.0% over the next five years, and households expect it to average 5.0%. This brings expectations back to the level seen a year ago. Naturally, this is still far above the CBI’s 2.5% inflation target, but it should also be noted that the five-year averages are affected by expectations of high inflation in the short run.

The newly published results of the CBI’s most recent market expectations survey indicate that market agents expect inflation to measure 4.0% over the next five years and roughly 3% over the five years thereafter. Furthermore, market expectations for inflation development in the coming 24 months drifted marginally downward between surveys.

Also, it should be noted that in the survey, the CBI asked about estimated risk premium in breakeven inflation. Judging by the median answer, market participants estimate the recent risk premium to be around 0.85%. To put that estimate in context, 5 year breakeven inflation in the bond market is currently around 4.9% and the 10 year breakeven roughly 4.5%. Adjusting for the risk premium estimate would result in bond market inflation expectations of roughly 4.0% for the coming 5 years and close to 3.6% for 10 years. Although obviously not consistent with the CBI’s target of 2.5%, this would reflect more faith in the effectiveness of monetary policy in the coming decade than could be inferred by looking at the unadjusted breakeven.

Real interest rates have risen

Real interest rates in Iceland have turned a corner in recent quarters. They are now positive by all measures and have risen markedly since the beginning of 2023, in terms of both short-term rates and bond market yields. Our calculations suggest that the CBI’s real policy rate has been around 2.9% in recent weeks in terms a simple average of one-year inflation expectations, and just under 1.7% in terms of recent inflation.

The long-term real rate in the bond market has actually fallen somewhat in recent weeks but, in terms of the yield on Treasury bonds with a ten-year duration, was slightly below 3% at the time of the last policy rate decision. As of this writing, the yield on these bonds is 2.7%, up from 2% at the turn of the year and 1.8% twelve months ago. Both short- and long-term real rates therefore appear to be somewhat above their equilibrium level, although by some measures the difference is perhaps small because of persistent inflation and demand pressures in the economy.

When will interest rates fall again?

Policy rate developments in the next few months, just like next week’s decision, could be affected by the geological situation in the Reykjanes area. If uncertainty recedes in coming months – either because the seismic unrest comes to an end or because it results in an eruption that causes relatively little damage – a policy rate increase is not entirely out of the question.

Considering that a natural disaster in Reykjanes could prove costly for Iceland in coming months, and considering that the economic and inflation situation could at best turn out modestly favourable for monetary policy – even if the current seismic activity concludes without a major shock to the economy – we think it most likely that the CBI’s monetary tightening phase came to an end in Q3.

Exactly when policy rate reductions begin will then depend on how fast inflation falls and how swiftly demand pressures in the economy ease. If the coming winter turns out considerably more onerous for households and businesses than we and the CBI have projected, interest rates will fall sooner and faster than they would otherwise. This could happen both because of severely negative economic repercussions of a natural disaster and because the impact of higher interest rates on households and businesses escalates rapidly over the course of the winter.

On the other hand, the possibility cannot be excluded that inflation will turn out even more persistent and demand pressures in the economy even more stubborn than we and others have projected in recent forecasts. Such a thing could transpire if wages rise much more sharply in 2024 than the 8% we forecast in late September. Were that to happen, the wait for a lower policy rate could be quite a long one.

Nevertheless, we think it most probable that a monetary easing phase will commence in spring 2024. Thereafter, the policy rate will fall gradually as inflation eases, possibly reaching around 6% in two years’ time.


Jón Bjarki Bentsson

Chief economist