Year begins with unchanged policy rate
The Central Bank (CBI) policy rate is unchanged at 4.25% after the Monetary Policy Committee’s (MPC) first interest rate decision of the year, published this morning. The MPC appears generally satisfied with the monetary stance and with economic conditions overall, and the policy rate could actually stay steady for some time to come. The CBI forecasts a soft landing after the current boom and believes that, by most key metrics, the economy will remain relatively well balanced for the rest of the decade. As often before, the Committee’s main concerns centre on upcoming wage negotiations and uncertainty about the fiscal stance.
Although the interest rate decision itself was in line with official forecasts, the relatively mild tone in the MPC statement seems to have taken many by surprise. As of this writing (11:00 hrs.) Treasury bond yields have fallen by 9-16 points since the market opened, indicating that market participants now think a policy rate hike in the near future is less likely than before.
CBI content with the current situation?
The forward guidance in this morning’s MPC statement is neutral. The last paragraph reads as follows:
The high real exchange rate has slowed export growth, and the outlook is for the positive output gap to narrow. Nevertheless, a tight monetary stance is needed to contain rapid domestic demand growth, in part because the outlook is for a less restrictive fiscal stance than previously expected. Furthermore, the outcome of wage settlements is still uncertain.
In the MPC’s December statement, however, the tone was sterner than it had been for most of 2017, and the Committee stressed the need for a tighter monetary stance “if fiscal policy in 2018 proves more accommodative than was [previously] assumed.” With today’s statement, the MPC is departing from that tone once again. Furthermore, this morning’s statement is quite brief, given that the CBI published its new macroeconomic and inflation forecast alongside it. This could indicate that the MPC is of the view the outlook is broadly unchanged and that there is no particular need to highlight new risks or uncertainties.
The bank is of the view that the expected fiscal easing will be offset by 2017-2018 output growth, which looks set to be weaker than previously forecast, and a narrower output gap. The slowdown in growth will be compounded by faster-than-expected growth in the working-age population.
CBI predicts a soft landing
The CBI’s new macroeconomic forecast estimates output growth at 3.4% in 2017, followed by 3.2% this year and 3.0% in 2019. In its last forecast, published in November, the GDP growth projections were 3.7%, 3.4%, and 2.5%, respectively. The assumption of slower growth in 2017-2018 in the current forecast is based largely on weaker export growth in 2017 and stronger import growth in 2018. On the other hand, the new forecast provides for stronger public consumption growth over the horizon as a whole and stronger investment growth in 2018 than the previous forecast did. In broad terms, the CBI expects a scenario similar to that described in our own recent macroeconomic forecast, which provided for 2.3% output growth in both 2018 and 2019, on the heels of 4.1% growth in 2017. In our view, this represents a relatively soft landing, and based on the CBI’s new forecast, the bank appears to share that opinion.
The CBI expects the current account surplus to shrink from an estimated 3.5% of GDP in 2017 to 1.9% and 1.5%, respectively, in 2018 and 2019. This accords with our forecast, which assumes that the high real exchange rate will continue to stimulate imports and impede export growth.
CBI views inflation outlook as broadly favourable
The CBI’s new inflation forecast is similar to its predecessor. The bank’s main inflation forecast now projects that inflation will average 2.6% this year and 2.2% in 2019. This differs somewhat from our own forecast, which assumes 2.3% inflation this year and 2.8% in 2019. However, the main forecast includes the assumption that the higher VAT rate in Iceland’s two-tier VAT system will be reduced at year-end 2018. We do not make this assumption in our inflation forecast due to the uncertainty about whether the current government will implement this change. Therefore, our inflation forecast is more comparable to the CBI’s constant-tax forecast, which sees inflation at 2.7% in 2019. We agree with the CBI, however, that inflation will hover close to target for the rest of the decade.
According to this morning’s statement, the MPC is not deeply concerned about the uptick in inflation in January. The Committee points out that inflation expectations and the inflation outlook are consistent with the target and that house price inflation has eased and the pass-through effects from the previous ISK appreciation have subsided at the same time. In general, then, the MPC appears relatively satisfied with the current monetary stance. There are no strong indications that the policy rate will be changed in the near term, but as we noted in our policy rate forecast, published last week, there is some likelihood that the conditions for a modest rate cut will develop over the course of this year.