In May 2022, the CBI’s Monetary Policy Committee (MPC) agreed unanimously to raise the policy rate by 1 percentage point, according to the recently published minutes from its last meeting. They also discussed a rate hike of 0.75 percentage points, however.

Committee members considered the main arguments for a rate hike to be as follows:

• The inflation outlook had deteriorated sharply in the recent past.
• Inflation expectations had also risen by all measures, and therefore, there was greater risk that they had become deanchored from the target.
• The real rate had therefore fallen even further between meetings; it was significantly negative and far below the equilibrium real rate.
• There was also a greater risk that near-term inflation was underestimated rather than overestimated, and uncertainty had increased.
• The labour market had recovered quickly and job numbers had risen considerably.
• Real disposable income and real wages had also grown markedly in recent years in spite of the pandemic-related economic contraction.
• Potential second-round effects from higher imported goods prices and wage hikes gave cause for concern as well.
• Demand in the housing market was stronger, house price inflation higher, and growth in the housing supply weaker than previously projected.

The main rationale for a smaller rather than larger rate hike was as follows:

• The global economic outlook could worsen more than expected, which would cut into domestic GDP growth, all else being equal.
• Many households were tapping their accumulated savings more rapidly than before, and a portion of the increase in private consumption was pandemic-related.
• Moreover, the outlook for real wages had deteriorated and, as a result, it was possible that domestic economic activity would slow abruptly as the year progressed.

The minutes wrap up with this statement:

The MPC discussed that it was likely that the monetary stance would have to be tightened even further in coming months so as to ensure that inflation eases back to target within an acceptable time frame. Decisions taken at the corporate level, in the labour market, and in public sector finances would be a major determinant of how high interest rates must rise.

MPC members have stressed, both verbally and in writing, the necessity of bringing the real policy rate back into positive territory in coming months. It is still negative by all measures despite the nominal rate hike of 1 percentage point this May. It can therefore be considered abundantly clear that further rate hikes are needed to restore the real policy rate.

But there are various ways to estimate the real policy rate, and the most obvious one – subtracting the observed 12 month trailing inflation rate from the nominal policy rate – is generally not considered to illustrate the real policy rate effectively, as it compares past inflation and a forward-looking interest rate. A real policy rate estimated by comparing the interest rate level with inflation expectations and the breakeven inflation rate in the market is naturally somewhat higher than one estimated from past inflation. We calculate the current real policy rate at somewhere between -1.3 percentage points and -2.0 percentage points using those metrics.

Therefore, based on CBI officials’ recent statements and actions, steep rate hikes can be expected in the near future, so as to rein inflation in, keep inflation expectations under wraps, and push the real policy rate above zero.

 Policy rate set to rise sharply in coming months

In our recently published macroeconomic forecast, we project that the policy rate will rise relatively swiftly in coming months, peaking at 5-6% at the year-end. Provided that inflation and demand pressures have begun to ease, we expect the policy rate to remain unchanged well into next year and then start to fall again in H2/2023. That said, the short-term uncertainty in the forecast is concentrated on the upside. We think it unlikely that interest rates will be below 5% at the end of this year, but there is a significant probability that they will rise above 6%, particularly if inflation proves more recalcitrant than we have forecast. After mid-2023, we expect gradual easing towards the equilibrium real rate, which is probably in the 1-1.5% range. The nominal policy rate could therefore be around 4.5% at the end of the forecast horizon, although the situation is highly uncertain further ahead.

Yield curves in the market suggest that a sizeable policy rate hike has already been priced into long-term rates. Long-term base rates are now 5.3%, and real rates are around 1.0%. Long-term nominal rates have risen sharply in 2022 to date, but real rates are roughly where they were at the beginning of the year, fluctuations notwithstanding.

If the policy rate develops in line with our forecast, we think long-term rates will rise somewhat in coming quarters. Interest rates will then fall slowly and steadily, and by the end of the forecast horizon we expect long-term rates to approach equilibrium, which we estimate at around 4.5% for nominal rates and somewhere near 1.3% for the real rate.