Policy rate hike driven by deteriorating inflation outlook
A worsening inflation outlook and rising inflation expectations were the main reasons the CBI raised its policy rate by 0.25 percentage points this morning. However, based on the forward guidance in the Monetary Policy Committee’s (MPC) statement, it is not a given that further rate hikes will follow in the next few months. Whether more rate hikes are to come will depend on whether the inflation outlook deteriorates further and how quickly growth in private consumption and investment tapers off in the near future.
First rate hike in three years
According to this morning’s statement, the MPC decided to increase the policy rate, raising the bank’s key interest rate – the rate on seven-day term deposits – from 4.25% to 4.5%. This is the first policy rate increase since November 2015 and the first change in any direction since October 2017.
The MPC statement explains the rate hike as follows: “Higher inflation and inflation expectations in recent months have lowered the Central Bank’s real rate more than is desirable in view of current economic developments and prospects.” The statement also points out that inflation expectations are above the 2.5% inflation target by all measures, and the inflation outlook has deteriorated, although the outlook is for “growth in economic activity to ease faster than previously expected.”
Additional rate hikes in coming months?
The forward guidance in this morning’s MPC statement is unchanged from that in its October statement. This morning’s statement is relatively stern in tone, but it does not signal further monetary tightening in coming months as strongly as many had expected. The Governor characterised the MPC’s short-term guidance as neutral. As before, developments in inflation and inflation expectations will be key factors in upcoming interest rate decisions. Other factors of importance are GDP growth — how rapidly it eases, and therefore how quickly the output gap narrows — and the results of the upcoming wage negotiations. The MPC reiterates yet again that “it has both the will and the tools necessary to keep inflation at target over the long term. If inflation expectations continue to rise and remain persistently at a level above the target, it will call for a tighter monetary stance.”
Muted optimism in the CBI’s macroeconomic forecast
The CBI’s new macroeconomic forecast, published this morning in Monetary Bulletin, provides for somewhat stronger output growth (4.4%) in 2018 than the last one did (3.6%). For 2019, the bank forecasts output growth at 2.7%. This represents considerably stronger growth than we have forecast for the two years combined. The difference lies in the CBI’s projection of weaker import growth in 2018 and significantly stronger domestic demand growth in 2019 relative to our own forecast.
In addition, the CBI now projects that inflation will rise swiftly, peaking at 3.5% in mid-2019, and then taper off, approaching the target by end-2020. This is somewhat lower inflation than we have forecast, although we also assume that inflation will taper off further ahead.
ISK and wage agreements among key uncertainties
At the press conference following the interest rate decision, CBI officials made much of the uncertainty entailed in the upcoming wage negotiations. Chief Economist Þórarinn G. Pétursson expressed the view that wage-related uncertainty in coming years is concentrated on the upside, based on the bank’s forecast, but he also noted that the CBI forecast provides for significant pay rises early in the forecast horizon.
He also mentioned that the ISK was probably fairly close to its equilibrium value following the depreciation in recent weeks, and that the equilibrium real exchange rate had probably fallen due to poorer terms of trade and a less favourable outlook for exports. The CBI projects, however, that the exchange rate will rise slightly from its current value in 2019 and then remain broadly stable in the years thereafter.