In early February, all MPC members agreed that the policy rate should be raised, and increases of 0.5-1.0 percentage point were under discussion. Ultimately, all members supported Governor Ásgeir Jónsson’s proposed 50-bp rate hike, although one member, Herdís Steingrímsdóttir, would have preferred to raise rates by 75 bp.

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

• The inflation outlook had deteriorated sharply once again.
• It would probably take longer than previously assumed to bring inflation back to target, due to steep pay rises and other signs of increased inflationary pressures.
• Inflation had remained high for some time, and consequently, there was greater risk of its becoming entrenched.
• There were few signs that inflation had begun to subside, and the share of CPI components that had risen far in excess of the inflation target in the previous year was still growing, as inflation excluding housing was still rising sharply.
• The labour market was considerably tight, and domestic demand was strong.
• The newly negotiated wage agreements were costlier and more front-loaded than had been assumed at the MPC’s previous meeting.
• Not all wage agreements had been finalised, and pay rises therefore could turn out larger than anticipated.
• Furthermore, the ISK had depreciated during the period before the interest rate decision, which would lead to higher imported inflation, all else being equal.
• The fiscal stance in the National Budget looked set to be more accommodative than had been provided for in the fiscal budget proposal.
• The monetary stance had also eased between meetings despite the interest rate hike at the Committee’s previous meeting.

The main arguments in favour of a smaller rather than larger rate increase were as follows:

• There were clear signs of a slowdown in the housing market, and nominal house prices in greater Reykjavík had fallen marginally.
• The Bank’s policy actions had clearly begun to affect the market; for example, growth in lending to households had lost pace.
• There were signs that private consumption growth had slowed, and pessimism among households had increased in the recent term.
• Underlying inflation had been unchanged in January, although it was too soon to say whether it had peaked.

In February, the MPC considered it likely that further rate hikes would be needed in the near future, as can be seen in its unusually laconic forward guidance:

The MPC considers it likely that the monetary stance will have to be tightened even further in the coming term so as to ensure that inflation eases back to target within an acceptable time frame.

The inflation outlook has deteriorated in many respects since the February policy rate decision, although a few things have developed favourably. But the good news will do little to change the MPC’s conviction that further monetary tightening is needed.

Below is a summary of the factors that will probably affect the MPC’s March decision.

In our opinion, these factors make it highly likely that a sizeable rate hike is in the offing.

The economy is humming along at a good clip, although weaker growth lies ahead

GDP growth has been strong in Iceland recently, and signs of expansion are widespread. According to Statistics Iceland’s (SI) newly published preliminary figures, GDP grew by 6.4% in 2022. It was Iceland’s fastest growth rate since 2007, albeit below both the CBI’s early February forecast and our own. On the other hand, growth in national expenditure, which can be viewed as a reflection of domestic demand, was far stronger in 2022 than the above-mentioned forecasts had provided for. It is worth bearing in mind, though, that growth in GDP and domestic demand eased in the latter half of the year.

The outlook is for GDP growth to be considerably weaker in 2023, and probably driven more by exports and less by growth in demand than in the past two years. According to our macroeconomic forecast from early February, GDP growth will measure 3.4% per year in 2023 and 2024 before tapering off to just under 3% in 2025, and the economy will move steadily towards better equilibrium in terms of domestic activity and external balance alike.

Even so, domestic demand still appears robust, if recent figures are anything to go by. For instance, payment card turnover data for January and February suggest significant growth in real private consumption, after sluggish growth in the months beforehand. This wintertime surge in consumption is probably due in fair measure to the wage agreements recently negotiated for a large share of the private sector, which gave wage-earners a double-barrelled shot in the arm in the form of direct rise in monthly pay and a clause making the new contracts retroactive to last November. Presumably, though, these effects will subside over the course of the year.

Inflation is high and widespread

SI’s most recent inflation measurements are hardly likely to bring a smile to MPC members’ faces. In February, headline inflation blew past the 10% barrier for the first time since autumn 2009. A number of factors combined to push inflation higher during the month. Inflation is quite widespread, and price pressures are nearly ubiquitous at the moment. This can be seen in the fact that all measures of underlying inflation rose in February, and all of them are far above the CBI’s inflation target.

In early February, the CBI projected that inflation would average 9.5% in Q1/2023 and fall to just under 6% by the end of the year. There seems to be little hope that the Q1 forecast will materialise, and we think inflation will be around 10% for the quarter and nearly 7% towards the year-end.

That said, there are two things about the near-term inflation outlook that could lift the MPC’s spirits.

• First of all, the recent tightening of the monetary and macroprudential stance, as seen in interest rate hikes and tighter borrowing requirements, has begun to affect the housing market quite strongly. The market value of residential property as shown in SI’s index calculations has fallen for three months in a row, and at an increasingly rapid rate. According to this measure, house prices nationwide have fallen by 0.7% since November 2022, and at the same time, housing supply, the average time-to-sale, the share of homes selling at a premium on the asking price, and other housing market indicators suggest that house prices will help curtail inflation in coming quarters, after having been one of its main drivers of the past two years.

• Second, the ISK has firmed up once again after a slide dating back to last autumn. The exchange rate is now broadly where it was at the turn of the year, whereas in February, the depreciation and its impact on imported inflation were among the MPC’s grounds for a sizeable interest rate increase.
  Moreover, bond market yields indicate that the interest rate differential with abroad has widened significantly in the recent term. Foreign bond markets have been highly volatile in recent weeks, and yields have fallen on both sides of the Atlantic in the wake of the failure of a few US banks in the past week or so.

The long-term interest rate spread vis-à-vis the euro and the pound sterling is now about the same as in late summer 2022, and the ten-year spread versus the US dollar is at its largest since late 2016. All else being equal, a wider exchange rate differential supports the ISK. At the same time, the outlook is good for exports of goods and services over the next few quarters, and foreign prices of various inputs for the manufacture of foodstuffs and other products have either held stable or fallen once again. As a result, imported inflation could subside markedly in the coming term.

Inflation expectations are high

New data on households’, businesses’, and market agents’ inflation expectations are not available. In February, though, the most recent measurements showed relatively little change from previous numbers, even if they were inching in the right direction by some measures.

Market expectations as measured by the spread between indexed and nominal Treasury bonds have fluctuated widely since the February interest rate decision, however. The breakeven inflation rate in the bond market rose steadily over the course of February, peaking just after SI’s month-end publication of the CPI, which had risen considerably more than generally anticipated.

In the past few days, however, the breakeven rate has settled down again, fuelled by the appreciation of the ISK and, more recently, the news about banking system turmoil in the US, which could make an impact on economic developments abroad and have already affected interest rate expectations in major currency areas quite a bit.

The breakeven rate in the Icelandic bond market is still very high in spite of the recent decline. The five-year rate is now approximately 5.6%, and the ten-year rate is 4.7%. The five-year breakeven rate five years ahead (which more or less covers 2028-2032) is now roughly 3.9%, as compared with 3.6% at the time of the last policy rate decision. Market premia are therefore far above the CBI’s 2.5% inflation target.

As always, it should be borne in mind that not only does the breakeven inflation rate capture inflation expectations, but it also includes an uncertainty premium, as investors can guarantee themselves a given real return by buying indexed bonds and holding them to maturity but have no such option in the case of nominal bonds. This uncertainty premium is doubtless rather high these days, owing to the volatile economic and inflation outlook both in Iceland and globally. All that said, the CBI will certainly want to see the breakeven rate fall somewhat, particularly the long-term measures. The MPC can hardly scarcely loosen the monetary stance in coming quarters without a drop in inflation expectations, whether in terms of actual measurements or the breakeven rate.

The market expects a further policy rate hike

In the recent past, yield curves in the market have reflected expectations of a sizeable policy rate hike. Nominal Treasury bond yields have been on the decline in the past few days, though: the two-year yield is just over 8% and the ten-year yield just under 7%. As with the breakeven inflation rate does, the nominal yield curve can be assumed to capture uncertainty about short-run interest rates in the coming term; however, it indicates strongly that market participants expect a further policy rate hike in the near future and relatively high interest rates over the next few years.

Real rates in the bond market have also risen considerably in recent quarters, showing that the tighter monetary stance has passed through to long-term rates. For example, the yield on indexed Treasury bonds with a ten-year average duration is now just over 2%, up from approximately 0.5% a year ago. The same is true of the real policy rate in terms of inflation expectations rather than past inflation.

It can be said that estimating the real policy rate by comparing the current nominal policy rate against twelve-month (past) inflation is like looking ahead with one eye and looking back with the other. As the chart shows, the real policy rate according to the forward-looking measure has risen sharply, on average, since mid-2022. It is not terribly high by most measures, though, and should probably be higher, given the current buoyant economy and elevated inflation.

Policy rate likely to peak in mid-2023

Another interest rate increase is probably in the cards for the only rate-setting meeting in Q2/2023. The policy rate is likely to be at least 7.5% at mid-year, so if next week’s rate hike is smaller, the one in May will probably be that much larger, and vice versa. Whether rates are raised further in H2 will depend on developments in inflation and the economy more broadly. Based on our most recent macroeconomic and inflation forecasts, the CBI could call it quits at 7.5% and leave the policy rate there for the remainder of the year. A gradual monetary easing phase would then follow, as inflation eases and demand pressures in the economy subside. The uncertainty in this forecast is tilted to the upside, however, unless inflation changes unexpectedly for the better or the economy changes for the worse.

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