The CBI’s most recent interest rate decision dates have been unusually far apart, which doubtless plays a role in how large the rate hikes were at the last two, in mid-November 2021 and early February 2022. On both of those occasions, the MPC decided to raise rates by 0.75 percentage points, and both times the decision was unanimous.

At the February meeting, there was a consensus among members on raising the policy rate by 0.75 percentage points, but they discussed rate hikes ranging from 0.50 percentage points to 1.00 percentage point.

The main arguments for taking the smaller step were as follows:

• Inflation was already expected to gain steam at the time of the November rate hike, although the increase had turned out larger than had been anticipated then.
• Some of the price hikes were pandemic-related and beyond the scope of monetary policy, and the impact of these would probably taper off in the coming term.
• A larger share of households now had non-indexed variable-rate mortgages, and the effects of interest rate hikes would therefore surface more quickly than in the past.
• The effects of the macroprudential tools applied last year had yet to come fully to the fore.

The main arguments in favour of the larger step were these:

• The inflation outlook had deteriorated markedly, and it appeared that inflation would subside to target more slowly than previously thought.
• Long-term inflation expectations had risen since the Committee’s November meeting.
• Concerns about potential second-round effects from rising domestic goods prices and wages could surface in larger and more widespread increases in the price of goods and services.
• Inflation was already relatively widespread, as underlying inflation had also risen and had been persistent.
• Because the economic recovery had begun, the slack in output had probably closed, and unemployment was set to continue falling, it would be appropriate to respond more decisively to the persistent rise in inflation, worsening inflation outlook, and rise in inflation expectations.
• The real rate had fallen markedly between MPC meetings, and it would be necessary to raise nominal interest rates somewhat in order to tighten the monetary stance.

Many of these considerations are likely to play a dominant role in the MPC’s May decision as well. But several of the factors that the MPC considered grounds for a larger rate hike rather than a smaller one must still give cause for concern, and some of them have moved in a distinctly unfavourable direction in recent weeks and months. Below is a summary of the factors that we expect to affect the MPC’s deliberations in early May:

Economic recovery well underway, but the war in Ukraine amplifies uncertainty

The Icelandic economy is chugging along at a good pace after the blow it sustained with the spread of the COVID-19 pandemic. The recovery has exceeded expectations, and the persistent negative impact of the pandemic on external trade and domestic demand appears likely to be weaker than widely feared. Unemployment has returned to its pre-pandemic level, and payment card turnover indicates that Icelanders’ consumption behaviour has done likewise. Also, net new domestic lending has been growing at a fairly rapid clip in spite of rising rates. Furthermore, the outlook is for a surge in exports in 2022, largely because of a rapid rise in tourist numbers, plus favourable growth prospects for other exports.

Uncertainty about the near-term economic outlook has mounted since Russia invaded Ukraine, which has had a strongly negative effect on the global economic outlook for coming quarters. In the International Monetary Fund’s (IMF) most recent macroeconomic forecast, for instance, global GDP growth is projected to be 0.8% weaker this year, and 0.2% weaker in 2023, than the Fund assumed in January. The downward revision is due mainly to the direct and indirect impact of the war.

The Icelandic economy could be considerably affected because of disruptions in external trade and the adverse effects that steep price hikes in global markets will have on Icelanders’ spending capacity and investment, to mention just a few factors. The Icelandic economy is better positioned than many others, however, due to a number of factors:

• Iceland conducts very little trade with Russia, Ukraine, and Belarus
• Its own main export commidities have risen in price in recent months
• The inflationary impact is weaker in Iceland than in most of Europe because of Iceland’s household energy self-sufficiency
• As yet, appetite for travel to Iceland appears relatively unaffected by the war

The MPC will doubtless bear these points in mind when it sets interest rates in May.

Inflation outlook darkens yet again

If the bleak short-term inflation outlook was a minor irritant for the MPC in February, it must be of far graver concern by now. Inflation measured 6.7% in March, its highest in nearly a dozen years. We expect it to keep rising in coming months, peak at 7.7% this summer, and taper off slowly thereafter. Just how inflation actually develops in the next few months is highly uncertain, and there is a significant risk that it will turn out higher and/or more persistent than we anticipate.

The inflation outlook for coming quarters has therefore deteriorated markedly since February, when the CBI published its last forecast. In February, the bank projected that inflation would peak at 5.8% in Q1/2022 and then begin to ease, falling below 3% by Q4/2023. Its new inflation forecast, to be published in Monetary Bulletin alongside the May interest rate decision, will doubtless sketch out a significantly darker picture of near-term inflation prospects. The MPC will have that forecast for reference when it meets in May.

To be sure, rising inflation and a worsening outlook are due in part to factors such as surging global market prices. These stem from growing demand coupled with supply-side bottlenecks, which in turn are caused by both the pandemic and the war in Ukraine. Naturally, these trends are beyond the control of the Central Bank of Iceland, and to some extent they should have a dampening effect on demand-driven inflation once higher import prices start to pinch Icelandic consumers’ wallets. In addition, part of domestic inflation stems from rapidly rising house prices, which affect Statistics Iceland’s (SI) inflation measurements much more directly than is the case in most other economies. Moreover, the rise in house prices is due in part to a lack of new housing on the market – problem that looks set to resolve itself to a large degree in the coming term.

But it is not least strong demand that has driven house price inflation in the recent past, and this the CBI can certainly affect by raising interest rates and tightening borrower-based measures. As yet, the CBI’s policy actions – interest rate hikes and reductions in maximum loan-to-value and debt service-to-income ratios – have had little obvious impact on the rise in house prices.

In addition, domestic inflation is quite widespread, affecting both goods and services. All measures, no matter which is used, indicate inflationary pressure well above the CBI’s inflation target. Inflation according to the CPI excluding housing is currently 4.6%, and inflation according to SI’s core indices (which exclude various volatile items) ranges between 3.7% and 6.9%.

Inflation is a global problem at the moment, and leading central banks are wrestling with the arduous task of trying to control high and rapidly rising inflation at a time when the economic outlook has deteriorated. The IMF forecasts an average inflation rate of 5.7% among advanced economies in 2022, and for emerging economies it projects an average of 8.7%.

As is discussed above, supply-chain disruptions – due to the pandemic and, more recently, the war in Ukraine and related economic sanctions – have pushed up the price of energy, a number of commodities and, as a result, various manufactured goods, as global demand is rising at the same time. Although house price inflation does not show in neighbouring countries’ inflation measurements in the same way as it does in Iceland, the price of energy for household use has surged abroad but remained relatively stable here. For example, headline inflation is currently higher in both the eurozone and the US than it is in Iceland.

This trend has upended interest rate expectations in most of the world’s leading economies, and it is now generally expected that average global policy rates will rise markedly in the coming term. For example, according to Reuters’ most recent summary of forecasters’ projections for the US policy rate, which was around zero at the beginning of the year, forecasters now expect it to be over 2% by the year-end. A similar summary for the UK indicates a median policy rate of 1.25% at the year-end, as compared with 0.25% at the beginning of the year. There are even growing expectations that the European Central Bank will raise its policy rate by the year-end, after keeping it close to zero for nearly eight years. In coming quarters, this will probably cut into the interest rate differential between Iceland and other countries despite rate hikes here, giving the CBI greater latitude to raise rates without running the risk of attracting large-scale inflows of volatile capital for carry trade, or other side effects of a large interest rate spread.

Inflation expectations on the rise

The MPC keeps close track of measures of long-term inflation expectations. These include the results of surveys taken among households, businesses, and financial market participants, as well as the breakeven inflation rate in the bond market. Developments in long-term expectations were cause for significant concern at its February meeting and will hardly be less so this time. The most recent survey findings suggest that households, corporate executives, and financial market agents all expect higher inflation in coming years than they did in previous surveys. It is a given that high short-term inflation affects respondents’ assessments of average inflation over the coming 5-10 years, even when the current inflationary episode is expected to be temporary and followed by a period of moderate inflation. So corporate executives’ expectations that inflation will average 3.2% over the next five years (according to the most recent survey results) could be construed to mean that they expect inflation to average 6% in 2022, followed by four years of target-level inflation. What remains, though, is that the MPC stated explicitly at its last meeting that the rise in long-term inflation expectations warranted a larger rate hike in February.

It is more difficult to explain developments in the breakeven inflation rate solely in terms of an unfavourable short-term outlook. The breakeven rate has risen throughout the year and is now far above the CBI’s inflation target by all measures. For instance, as of 22 April, the five-year breakeven rate had risen from 4.0% to 5.2% year-to-date and the seven-year rate from 3.6% to 4.7%. It must always be borne in mind, though, that the breakeven rate in the market generally includes a premium reflecting uncertainty about real returns on nominal bonds, so it is not solely an indication of expected average inflation. Such an uncertainty premium typically rises in times of significant short-term inflation volatility and elevated uncertainty about developments in upcoming quarters. It is unlikely, for instance, that the seven-year breakeven rate truly indicates a general expectation that inflation will average 4.7% over the next seven years. Nevertheless, the steep rise in breakeven rates in recent months will hardly give MPC members cause for cheer.

Real rate still negative

Even though the policy rate has been raised by 2.0 percentage points since May 2021, the increase in the real rate has been far smaller by most measures, as it is offset by rising inflation and inflation expectations, as well as the higher breakeven rate. In terms of a simple average of recent measures, we calculate the real policy rate at somewhere near -2.7%, as compared with -2.4% at the beginning of the year. Although such a back-of-the-envelope calculation should be interpreted with caution, it does suggest that the monetary stance is probably – at best – broadly where it was before the 75bp rate hike in early February.

It can be argued persuasively, then, that a higher nominal policy rate is needed to haul up the real rate, prevent inflation expectations from rising further, and reduce the risk that expectations will become unmoored from the target.

Monetary tightening to continue

As we see it, the CBI’s monetary tightening phase will be nowhere near at an end after the May decision, as the bank will presumably want to bring the real policy rate closer to equilibrium sooner rather than later. Initially, the CBI will have to rely mostly on nominal rate hikes to push the real rate upwards, but we hope and expect that declining inflation and more stable inflation expectations will provide some support before too long.

We think it likely that the policy rate will be raised by 0.25 percentage points in June, followed by rate hikes totalling at least 0.50 points in H2/2022. If these projections materialise, the policy rate will be 4.0% by the year-end. For 2023, we expect rate additional rate hikes totalling 0.50 percentage points or more, bringing the policy rate to 4.5-4.75% by the second half of that year, assuming that inflation has begun to subside markedly and approach the target by that time. If inflation proves more persistent and inflation expectations more intractable, the CBI will presumably have to raise rates faster and higher before the monetary tightening phase comes to an end.