The decision took many by surprise, as official forecasters (ourselves included) had expected no change in interest rates. Apparently, the MPC is less concerned about developments in the ongoing Delta wave of COVID-19, both in Iceland and abroad, than domestic and foreign financial analysts are. In our forecast, we projected that uncertainty related to the Delta variant would prompt the MPC to postpone monetary tightening until the autumn, when – hopefully – the outlook further ahead would have grown clearer. It is worth noting that the remaining policy rate decision dates for 2021 are unusually close together on the calendar, making it easier to respond to rapid changes in the economic outlook.

In this morning’s statement, the MPC noted that in spite of the Delta wave, the economic outlook was brighter than previously expected, the slack in the economy had narrowed more quickly, general inflationary pressures appeared to be subsiding, and the rise in inflation expectations was reversing. Nevertheless, the outlook was for inflation to remain high through 2021 and take a full year to align with the CBI’s 2.5% inflation target.

To put it as succinctly as possible, the improving economic outlook and the narrowing economic slack apparently outweigh the changed inflation outlook in the balancing exercise that generated today’s interest rate decision.

The forward guidance in this morning’s statement is neutral – and actually, a verbatim repeat of the May statement:

The MPC will apply the tools at its disposal to ensure that inflation eases back to the target within an acceptable time frame.

More optimistic macroeconomic forecast?

The CBI published a new macroeconomic forecast alongside today’s interest rate decision. The bank forecasts a brighter GDP growth outlook for 2021 as a whole, even though GDP contracted more in Q1/2021 than the CBI projected in May. The bank now projects 2021 GDP growth at 4%, up from 3.1% in the May forecast. The more favourable outlook is due mainly to strong growth in Q2, in tandem with reduced COVID case numbers, the relaxation of public health restrictions, and a faster-than-expected increase in tourist arrivals. What is noteworthy, though, is that the CBI’s forecast assumes only a 3% increase in tourist numbers relative to its May forecast. The GDP growth outlook for 2022, on the other hand, is rather bleaker than in the previous forecast. The CBI projects GDP growth for 2022 at 3.9%, as compared with 5.2% in the May forecast. Output growth for 2021 and 2022 combined is only marginally below the May forecast. We don’t think this is quite consistent with the upbeat tone in both the MPC statement and in this morning’s press conference.

Furthermore, the bank forecasts a lower unemployment rate than it did in May, as the slack in the economy has narrowed faster than was assumed then. According to the new forecast, registered unemployment is expected to average 8.1% this year but fall to its pre-COVID level of 4.3% by 2023, the end of the forecast horizon. When asked about the imbalances between job vacancies and demand for work, with employers citing difficulties in recruiting staff despite a high unemployment rate, Deputy Governor Rannveig Sigurðardóttir pointed out that it is too early to worry about this. Foreign nationals account for a share of the labour force, and these workers may well have gone back to their home country during the Corona Crisis. As a result, it will take time for foreign workers to return and for the labour market to rebalance.

Inflation outlook broadly unchanged

The CBI has raised its inflation forecast slightly since the spring. It attributes inflation persistence to two factors: higher inflation at the beginning of the forecast horizon and unexpectedly large jumps in the price of oil and other commodities. The bank forecasts that inflation will average 4.2% this year and 2.8% next year. According to the CBI’s most recent forecast, inflation will reach the target in Q3/2022, which is in line with our own forecast.

Inflation currently measures 4.3% and has been unusually stubborn, owing to a buoyant real estate market and rising private services prices, which in turn stem from a surge in demand after public health measures were relaxed.

CBI captains think this is the right time to tighten monetary policy

At the press conference this morning, Governor Ásgeir Jónsson was asked why the CBI was so keen to raise rates in Iceland, unlike what most neighbouring central banks are doing – especially in view of the short-term uncertainty brought on by the Delta wave. In response, Ásgeir said the CBI’s real rate was still at rock-bottom, and the bank wanted to respond in a timely manner to the aforementioned economic and inflation outlook. It was clear that he was not deeply concerned about what the Delta variant might do to the economic recovery in the quarters to come. Deputy Governor Rannveig Sigurðardóttir added that the CBI’s forecast of declining inflation was based on the assumption of a specific policy rate path, and she implied that rising rates would be needed to bring inflation back to target within the forecasted one-year time frame. Chief Economist Þórarinn G. Pétursson noted as well that in other countries the challenge lies most often in pulling inflation expectations upwards, whereas the opposite is true in Iceland.

CBI officials also think last year’s policy rate cuts had a strong impact on asset prices. The rise in house prices was the main roadblock to disinflation this summer. The housing market was not showing signs of a bubble, but rather an imbalance between weak supply and burgeoning demand. The rate hike now was to some extent intended to cool down the property market. The same could be said of the real economy. Last year’s rate cuts had boosted disposable income, and the wealth effect experienced by many households had stimulated demand.

It is clear from the words and deeds of the CBI’s leadership that they believe the bank’s actions to have been effective in cushioning against the blow from the Corona Crisis. We agree wholeheartedly. But they also think there is now ample reason to respond to the improving outlook as soon as possible by scaling down the incentive provided by an accommodative monetary stance. On this point, we question the wisdom of the timing. It certainly appears that a strong economic recovery and significant inflationary pressures will call for monetary tightening sooner rather than later. Just last week, in fact, we projected that the policy rate would be up to at least 2.0% by the end of 2022. Given how much uncertainty still prevails about the impact of Delta on the global economy, the recovery of tourism, and domestic economic activity, and given the short time between upcoming interest rate decision dates, we would have thought it more sensible to wait and see what the next several weeks bring. We hope developments will justify the CBI’s optimism. If all goes well, perhaps another rate increase will be forthcoming in Q4. If not, we expect the next rate hike to come after the turn of the year.