As could be discerned from the MPC’s November statement and the ensuing press conference, uncertainty about developments and prospects relating to the seismic unrest in the Reykjanes area tipped the balance in favour of an unchanged policy rate this time. We believe the Committee would probably have voted to raise rates had it not been for that uncertainty. Actually, the MPC’s newest member, Ásgerður Ósk Pétursdóttir, stated outright in an interview with Iceland Financial News that she would have voted to raise rates in November if the geological situation had not been so volatile.

The MPC discussed the following key arguments in favour of an unchanged policy rate in November:

• It was appropriate to wait and see, owing to uncertainty about how the seismic unrest would affect the economy, especially Government finances, tourism, and the housing market (and therefore inflation). As is noted above, this argument tipped the scales in favour of an unchanged policy rate in November.
• Economic activity had continued to lose pace, and growth in private consumption and investment had subsided.
• The effects of previous interest rate hikes were clearly coming to the fore, the real rate had risen since H1/2023, and consumers were more pessimistic about the economic outlook.
• Indexed lending rates had risen as well in the recent past, in tandem with the rise in the real rate, and all else being equal, this could reduce demand for loans.

The main arguments in favour of a rate hike were as follows:

• The Committee considered it cause for considerable concern that inflation was so persistent and that the inflation outlook had deteriorated again.
• The outlook was still for robust GDP growth, the output gap was larger than previously estimated, and the labour market remained quite tight.
• House prices were still rising, and mortgage lending growth had picked up again.
• Even though indicators implied that domestic demand had eased, they were not unequivocal.
• It was therefore probable that the monetary stance was not tight enough to bring inflation back to target within an acceptable time frame.
• Had it not been for the uncertainty about a possible volcanic eruption, the need for a tighter stance would therefore have been broadly the same as at the previous meeting.
• Given how persistent inflation was, and given the outlook for a slow disinflation process, there was greater risk that inflation would become entrenched at a level well above the target.
• Because of this, tightening the monetary stance too little was riskier than tightening it too much.

It was pointed out at the MPC meeting that in view of the poorer inflation outlook, and because economic activity was still relatively brisk, it would probably have been appropriate to raise interest rates further had it not been for the uncertainty arising from the Reykjanes situation. In addition, concerns were expressed that if inflationary pressures should begin mounting again, it could prove necessary to raise interest rates more, and keep them high for longer, than would otherwise be needed.

Policy rate hike after the turn of the year?

To refresh readers’ memory, the Committee’s forward guidance in November was as follows:

Although the effects of recent interest rate hikes are coming more clearly to the fore, the poorer inflation outlook suggests that it may prove necessary to tighten the monetary stance still further. In spite of this, the MPC has decided to keep the key interest rate unchanged, owing to uncertainty about the economic impact of seismic activity on the Reykjanes peninsula. As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

Given that concerns about an imminent major disaster on the Reykjanes peninsula have abated significantly since the November policy rate decision, a rate hike on the next decision date, 7 February 2024, has to be considered at least fairly likely.

The main factors we think will affect the MPC’s opinion in the interim are these:

• Recent indicators: The national accounts for the first nine month of 2023 suggest that economic activity has slowed quite a bit more abruptly than the CBI projected in its November forecast. The bank forecast Q3 GDP growth at 1.75%, whereas the actual growth rate was 1.1%.
• The 2024 fiscal budget: Parliamentary handling of the 2024 fiscal budget is now in the final stages. It still appears most likely that amendments to the original budget proposal will be modest, but uncertainty is concentrated on the upside; i.e., the fiscal deficit will probably be larger and the fiscal stance more accommodative than the budget proposal provided for.
• Inflation: Twelve-month inflation could fall markedly in January. In November, the CBI forecast that inflation would taper off noticeably after the turn of the year, falling from 7.9% in Q4/2023 to 6.8% in Q1/2024. The January figure will set the tone, and if it exceeds expectations, a rate hike will be that much more probable.
• Wage agreements: Wage agreements for most of the private sector are set to expire at the end of January. In recent interviews, the Governor of the CBI has said that a more positive tone could be detected from the social partners regarding a potential reboot of the national consensus on inflation – call it National Reconciliation 2.0 – which would provide for modest wage rises concurrent with voluntary price controls for private sector companies and moderate increases in public levies. If wage contracts are concluded in this vein, or if the negotiation process is at a particularly sensitive stage, the MPC could opt for a wait-and-see approach.
• The ISK: The depreciation of the ISK from early September through the latter half of November put a bad taste in MPC members’ mouths. Since the November policy rate decision, however, the ISK has appreciated by nearly 2.5%. Further strengthening between now and end-January would tend to reduce the likelihood of a rate hike, while weakening would have the reverse effect.

• Inflation expectations: New measurements of households’, businesses’, and market agents’ inflation expectations will be available by the beginning of February. These, together with developments in the breakeven inflation rate in the bond market, could affect the MPC, given members’ concerns about persistently high inflation expectations.
• Geological unrest on the Reykjanes peninsula: It is still unclear how seismic activity will develop on the Reykjanes peninsula and whether there will be a volcanic eruption in the region. A sharp escalation of uncertainty – not to mention a possible eruption affecting infrastructure and economic activity in the southwest corner of the country – could eclipse other considerations, as it did in November.

As a result, it is difficult to ascertain whether the CBI’s monetary tightening episode will continue in February or whether the August rate hike will turn out to have been the last one. In any event, we do not think a significant further rate hike is likely. Nevertheless, the possibility cannot be excluded that the MPC will need to tighten the monetary stance quite a bit more if further disinflation is slow in coming in H1/2024, or if inflation should rise higher once again.