In late March, when the MPC last met, all members agreed that the policy rate should be raised, and the issue was whether to raise it by 75 or 100 basis points. The Committee was unanimous in opting for the larger rate hike, however.

The main reasons for such a big rate increase in March were as follows:

• Inflationary pressures were still strong, and the economy was running quite hot.
• Domestic demand had been more resilient than expected, and large pay rises and tension in the labour market manifested themselves in increased cost pressures.
• It seemed that a large proportion of the increased cost pressures had been passed directly through to the price level, and there was the risk that this would continue in coming months.
• Strong demand gave rise to the risk that last year’s decline in global oil and commodity prices and reduced shipping costs would take longer to deliver lower prices in Iceland.
• Inflation was still on the rise in many trading partner countries.
• Growth in credit system lending to businesses was still gaining pace in spite of interest rate hikes, and the majority of the loans bore variable interest rates.
• The fiscal stance would probably be more accommodative in 2023 than previously assumed.
• It was vital to make discernible progress quickly, given how widespread inflation was, how high inflation expectations were, and how little time there was until the next wage agreements.

The main arguments in favour taking the smaller step were these:

• Housing market activity had slowed down, and it was clear that the Bank’s actions had affected the market.
• Poorer financial conditions could accelerate the downturn in economic activity, and inflation could therefore fall faster than was projected at that time

Members considered it crucial to ensure that inflation would fall swiftly and reliably in the near future, even though the measures taken could have a substantial impact on economic activity. It was essential to push back against the second-round effects of cost increases on the price level that now appeared to have emerged, and to ensure that the monetary stance would tighten quickly.

Even though the MPC’s forward guidance was not as unequivocal about the need for further monetary tightening as it had been in February, CBI officials stated unambiguously in the wake of the decision that they would do whatever was needed to bring inflation under control in the coming term.

There have been few favourable developments in the inflation outlook since the MPC’s last rate-setting meeting, but in a spirit of goodwill one can pinpoint a few indications that the rate hikes of the recent past have begun to have a palpable impact.

Below is a summary of the factors that will probably affect the Committee’ May decision.

The Icelandic economy is still cantering along at a good clip

There are numerous signs that the economy has been growing briskly in the first four months of 2023. The winter season was a bountiful one for the tourism industry, as we have discussed recently. It looks clear that tourism is back to full speed after the pandemic, or very nearly so, and the outlook is bright for the coming term. Furthermore, Icelanders’ payment card turnover surged in real terms in the early months of the year, and figures on imports suggest that investment in transportation equipment grew strongly. Unemployment has been low at a time of robust population growth, and worker shortages still appear to be fairly widespread, although they have subsided a bit since last autumn.

On the other hand, there are more and more indications that growth in demand will lose momentum as the year advances. Recent expectations surveys conducted among households and businesses show a significant decline in optimism about the economic outlook. Furthermore, consumers look set to hold back on buying big-ticket items such as overseas travel, motor vehicles, and housing in the near term, and firms planning to scale down investment this year outnumber those planning a year-on-year increase. Moreover, domestic payment card turnover in Icelandic stores has slowed down steadily, even contracting in real terms in April – for the first time since October 2022.

In March, the MPC noted that domestic demand had proven more resilient than expected and the labour market remained tight. Developments since then have probably been broadly in line with Committee members’ expectations, and in our opinion, that alone would not necessarily call for a hefty rate hike now if there weren’t other contributing factors.

The inflation outlook has deteriorated …

Inflation has been particularly persistent in 2023 to date. In addition, inflationary pressures appear to be growing steadily more broad-based, and underlying inflation has risen markedly year-to-date by all measures. On top of this, house prices started rising again last month, after the MPC had pointed out in March that the cooler housing market was one of few signs that a tighter monetary stance had begun to deliver the desired results.

In early February, the CBI forecast that inflation would average 7.7% in Q2/2023 inflation and then taper off steadily, falling below 6% in Q4. But according to our newly published inflation forecast, inflation looks set to measure 9.7% in Q2 and still be over 7% in Q4.

Presumably, the CBI’s forthcoming inflation forecast, set for publication in Monetary Bulletin concurrent with next week’s interest rate decision, will be considerably gloomier about the near-term inflation outlook than the February forecast was. It can be seen in the minutes of the MPC’s March meeting that even then, Committee members had already begun to have doubts about the February forecast, and the outlook has certainly not improved in the interim.

… and inflation expectations are high

Expectations about inflation over the next few years are still well above the CBI’s 2.5% inflation target. That said, various measures of long-term expectations have held relatively stable in the recent past. The CBI has just published the results of its market expectations survey, which show that market agents’ long-term inflation expectations have risen somewhat between surveys.

The long-term breakeven inflation rate in the bond market has fallen from the high level seen in early March, however. While the breakeven rate is still considerably above the 2.5% target, it is important to bear two things in mind: first, the average breakeven rate for the next 5-10 years is affected by the short-term outlook, and second, the uncertainty premium on nominal Treasury bonds (another key variable in the calculation of the breakeven rate) is probably quite high at present.

The bond market expects a rate hike

Bond market yield curves reflect the expectation of a further policy rate increase in the near term. For instance, the interpolated yield on two-year Treasury bonds is now 8.5%, up from around 8% after the March interest rate decision. On the other hand, the market still expects interest rates to fall significantly later in the decade.

The newly published market expectations survey points in the same direction. According to the median response, market agents expect the CBI’s monetary tightening phase to end with a 100-bp rate hike in Q2, followed by an easing phase starting in 2024.

Although there is discernible impatience about when the effects of tighter monetary policy will start to bite in earnest, the rate hikes have already pushed the real rate higher by most measures. Twelve-month inflation is certainly well above the policy interest rate at present, but as we have discussed previously, it is not a particularly illustrative metric.

Real yields on long-term Treasury bonds have been relatively stable at around 2% since last autumn despite wide fluctuations in nominal Treasury bond yields. Furthermore, forward-looking measures of inflation show that the real policy rate has been rising steadily, although it is still relatively low in historical context. The monetary stance has therefore tightened by those measures, although more tightening is probably needed, given the current inflation persistence and overheated economy.

Will the policy rate hikes end in May?

The May interest rate decision will be followed by a long summer break for the MPC, with the next regular interest rate decision scheduled for late August. In our opinion, developments in inflation and economic activity between now and then will determine whether the monetary tightening phase comes to a close in May or whether more rate hikes can be expected in H2. If inflation eases in line with our most recent inflation forecast and clearer signs emerge of a slowdown in domestic demand growth, the tightening episode will probably end before mid-year. But virtually everything must fall into line if further rate hikes in H2 are to be avoided.

We think it most appropriate to encapsulate our forecast for coming quarters as follows: the policy rate will be at least 8.5% for the rest of this year, and the risks to the forecast are concentrated on the upside. As before, we hope and expect that as inflation falls and the economy rebalances, interest rates will start falling again in 2024. The easing phase will probably begin cautiously, though, and the outlook is for a relatively high policy rate until at least the middle of the 2020s.

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