Expectations of higher interest rates in the near term but moderate inflation further ahead

In general, market agents seem to expect policy rate hikes in coming quarters. Long-term inflation expectations still appear reasonably well in line with the Central Bank’s (CBI) inflation target, although the spread between expectations and the breakeven inflation rate in the market has widened noticeably in the recent term. On the other hand, a fair share of market participants now consider the CBI’s monetary stance too loose and therefore expect policy rate increases. 

Yesterday, the CBI published the results of its most recent survey of market agents’ expectations. The bank has been conducting such surveys since 2012, and the results are taken into consideration by the Monetary Policy Committee (MPC) in its assessment of a suitable monetary stance when it takes interest rate decisions. In the recent past, the MPC has kept well apprised of developments in long-term inflation expectations, which reflect the level of confidence in the CBI’s ability to keep inflation at the 2.5% target over the medium term. 

In short, though, the CBI can be reasonably well satisfied with the results of the new survey. To be sure, short-term expectations have risen markedly, with the average respondent expecting inflation one and two years ahead to measure 3.6%, an increase of 0.6 percentage points since the August survey. On the other hand, long-term inflation expectations have changed relatively little between surveys. According to the median response, market agents expect inflation to average 3.0% in the next five years and 2.9% in the next ten years. Based on the above-mentioned two-year expectations, it can be inferred that respondents expect inflation to average roughly 2.6% in 2021-2023 and 2.8% in 2024-2028.

Marked difference between breakeven rate and inflation expectations

In addition to direct surveys of inflation expectations, developments in the breakeven inflation rate in the bond market give a fairly strong indication of market agents’ assessment of probable developments in inflation. But the breakeven rate is affected by other factors as well. In general, uncertainty about real yields on non-indexed bonds should be reflected in the premium on these bond yields over and above the real yield on indexed bonds plus the expected rate of inflation. Furthermore, market conditions can affect the relative yields on indexed and non-indexed bonds. 

We believe both of these factors have caused the breakeven rate to rise recently. In particular, the mismatch between supply and demand for various Treasury bonds seems to have pushed the breakeven rate upwards since mid-year. In our opinion, a major factor in this is that the most active long-term investors in Iceland — the pension funds — have been especially keen to invest in household loans and foreign-denominated assets, while their foreign counterparts have been hindered in their efforts to invest in domestic bonds by the CBI’s capital flow management measure. 

As the chart shows, there is now a roughly 1.2 percentage point difference in the five-year breakeven rate in terms of Treasury bond yields versus market agents’ five-year inflation expectations. This is the widest spread since the CBI launched its market expectations survey in 2012.

Expect a higher policy rate

Based on market agents’ responses to the survey, they assume that the CBI will be compelled to respond to a worsening short-term inflation outlook and work systematically to mitigate inflationary pressures in coming quarters. Four out of ten respondents consider the monetary stance too loose at present, whereas none were of this opinion in the August survey. In addition, survey participants generally expect the policy rate to rise by the year-end, and they project that it will be 0.75 percentage points higher a year from now than it is today. 

This is a turnaround from the last survey, which indicated a general expectation that the policy rate would remain unchanged well into 2019. Whether the MPC decides to raise rates or not will come to light tomorrow morning. We expect it to hold the policy rate unchanged, although there is a decent probability of a rate hike. The results of the new survey are somewhat ambiguous in terms of the guidance they might offer the MPC, whose job is clearly quite complex at the moment.