The highlights from the MPC statement are as follows:

• Inflation has fallen since the Committee’s last meeting.
• Inflation excluding housing has fallen more rapidly, and underlying inflation is down to 5%.
• Growth in domestic demand has subsided, as the monetary stance is tight.
• The outlook is for a slowdown in GDP growth this year.
• The output gap is larger than previously estimated.
• In the labour market, demand pressures remain, which could give rise to wage drift.
• Inflation expectations have declined by some measures but remain above target.

The forward guidance in today’s MPC statement differs somewhat from that in the last statement, and in our opinion, the tone is milder.

It reads as follows:

The MPC is of the view that there is an increased probability that the current monetary stance is sufficient to bring inflation back to target within an acceptable time frame. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

In our estimation, this forward guidance is a sign that the MPC envisions lowering the policy rate if and when inflation and inflation expectations fall below their current level and thereby keep the real policy rate broadly where it is now. In this context, it is worth noting that at today’s press conference following the announcement of the interest rate decision, Governor Ásgeir Jónsson said that the Committee had the possibility of cutting rates quickly when the time came, and that perhaps it would be better “not to begin with measly little rate cuts at the wrong time – sizeable rate cuts at the right time would be preferable”.

GDP growth set to be weaker in 2024 and 2025 …

The CBI published its updated macroeconomic forecast in a new Monetary Bulletin today, concurrent with the interest rate decision. The bank has revised its 2024-2025 GDP growth projections downwards since its last forecast, issued in early February. It now expects growth to measure 1.1% this year instead of the February forecast of 1.9%, followed by 2.3% in 2025 (previously 2.9%) and 2.9% in 2026 (previously 2.7%). Apart from the pandemic-induced crisis year 2020, the 2024 output growth rate will be Iceland’s slowest in a dozen years.

For 2024, the downward revision is due both to slower growth in domestic demand (particularly private consumption and investment) and to weaker growth in exports. The latter stems from the capelin catch failure and a poorer-than-expected outlook for tourism. For 2025, the revision is attributable entirely to weaker growth in consumption and investment than in the previous forecast.

Pressures in the labour market on a slow, steady decline

The CBI expects job growth to be weaker than in the recent term. Pressures in the labour market are still in evidence, however, and could foster wage drift. The bank forecasts that tensions in the labour market will ease steadily and that unemployment will average 4.8% this year, followed by 4.9% and 4.2%, respectively, in 2025 and 2026. Furthermore, the bank thinks the labour market situation in Grindavík could push unemployment upwards in the coming term. Moreover, the outlook is for population growth to keep subsiding over the forecast horizon and for a slack in the labour market to open up in late 2024.

The CBI forecast also assumes that the impact of negotiated wage rises will be just over 4% per year over the forecast horizon, which, in terms of productivity growth, is far better aligned with the inflation target than the pay rises in previous wage agreements. On the other hand, the CBI expects considerable additional wage drift and projects that unit labour costs (i.e., adjusted for productivity growth) will rise by 6.5% this year, 3.9% in 2025, and 4.0% in 2026, well below last year’s 7.8% and the 2022 growth rate of 7.3%.

Ásgeir Jónsson specified at today’s press conference that the recent wage agreements made a positive contribution to the fight against inflation and that the risk of a wage-price spiral had been eliminated for the present. On the other hand, the contracts contain review clauses that could be triggered in mid-2025, which highlights the importance of lowering inflation significantly before that time.

Inflation outlook bleaker than before

In the updated forecast, the CBI projects that inflation will average 5.9% this year, 3.9% in 2025, and 2.8% in 2026. This represents a slower disinflation process than was depicted in the February forecast.

But a number of things changed between this spring’s two interest rate decision dates. In particular, Q1 inflation exceeded the CBI’s previous forecast, which affects its forecasts for coming quarters. Furthermore, revised GDP growth figures from Statistics Iceland (SI) show that growth was much stronger in recent years than the previous numbers had indicated. This is reflected in a number of factors, including the CBI’s assessment that the output gap is wider at present than was previously estimated. Finally, the housing market appears more intractable than previously envisioned, and presumably, this unexpected resilience has some direct and indirect impact on the CBI’s inflation forecast.

In its survey of market agents’ expectations, conducted prior to the interest rate decision date, the CBI asked respondents what effect they thought the change in SI’s calculation of imputed rent would have. A full 2/3 of survey participants said inflation would probably be higher in coming quarters than it would have been otherwise. The CBI itself does not share this opinion, however, and is of the view that uncertainty about the impact of the change on the inflation outlook is symmetric. Actually, the Governor seemed surprised that most market agents should expect the change to result in higher inflation. CBI officials were unanimous in the opinion that over time, the change would probably reduce inflation volatility and make the imputed rent component more comprehensible to the general public. We agree with the CBI on this point.

To be sure, we do think there is a certain risk that rent will rise faster than house prices in the near future, given that the ratio of house prices to rent has increased sharply since the pandemic-era housing market boom took hold. But it is important to bear a number of other factors in mind as well, including differences in the impact of real rates on the markets and differences in pricing. And last but not least, it is worth noting that a number of politicians have broached the subject of putting some sort of cap on rent price inflation. Although such manipulation could prove to be a band-aid rather than a cure, as other countries have experienced, it could cause SI’s rent price measurements to rise more slowly than the rental market as a whole. We broadly agree with the CBI, that it cannot be said with certainty that the change in methodology will have a substantial negative effect on inflation in the coming term.

Policy rate cut to await the autumn

The MPC’s summer break will be a long one, as the next rate-setting meeting is scheduled for 21 August, a good 15 weeks from now. This summer’s economic and inflation developments will determine whether the Committee celebrates the end of summer with a rate cut or decides to wait longer before unwinding the monetary policy stance.

We expect rate cuts totalling 0.50 percentage points in H2, leaving the policy rate at 8.75% by the year-end. Sizeable rate cuts could follow in 2025 if our projections of a cooler economy and declining inflation are borne out. We expect the policy rate to be down to 6-6.5% at the end of 2025.

It is interesting to compare our forecast with the CBI’s recent market expectations survey results. According to the survey, expectations about the policy rate have shifted later in time than in previous surveys, which had assumed that rate cuts would start this spring. According to the median response in the survey, market participants expect the CBI’s monetary easing phase to begin in Q3. They expect the policy rate to measure 8.5% at the end of this year and 7.25% in spring 2025.

As the chart shows, survey respondents are slightly more optimistic than we are about rate cuts in coming quarters but considerably more pessimistic about longer-range developments. We need hardly mention that uncertainty grows swiftly further out the horizon, particularly as compared with uncertainty about the longer-term economic and inflation outlook.

After today’s MPC statement and press conference, we think our forecast of a Q3 policy rate cut stands on a stronger footing, and we detect that CBI officials may well be open to a hefty reduction when conditions warrant it.