But we also think there is a decent probability that the MPC will decide to raise interest rates by 0.50 percentage points this time, and opinion could well be divided among Committee members. The deteriorating short-term inflation outlook and rising long-term inflation expectations will be important factors in the MPC’s decision, although the Committee will also consider the improving economic situation despite the fluctuations in the pandemic since the last rate-setting meeting. Concerns about the impact on indebted households and vulnerable sectors of the economy would be the main reason the MPC might take a smaller step in raising rates. If the smaller step is taken this time, however, the likelihood of a larger rate hike in Q2 will be greater.

Several weeks have passed since the last interest rate decision, which was in mid-November, and the next one will not take place until early May. In other words, the February decision date is the only one on the roster over a period of nearly six months. In our view, this is unfortunate, as both the inflation outlook and inflation expectations have changed swiftly, and short-term uncertainty is still substantial. Certainly the CBI could intersperse an extra rate-setting meeting between February and May if need be, but it would have been better to spread the year’s regularly scheduled decision dates more evenly than has been done.

At the November meeting, all MPC members agreed to raise interest rates by 0.50 percentage points, although they did discuss rate hikes ranging from 0.25-0.75 percentage points.

The main arguments for taking a smaller step were:

• Interest rate hikes would probably affect households more than in the past, owing to the rising share of non-indexed, variable-rate mortgages.
• The impact of the interaction between rate hikes and the recent application of macroprudential tools had yet to come to the fore.
• Unemployment could rise again when Government support measures were withdrawn.
• The economic recovery could prove fragile.
• Some of the current inflation was due to temporary factors such as rising petrol prices and supply-chain disruptions, which are beyond the control of monetary policy.
• Underlying inflation appeared to have declined in recent months.

The main arguments for taking a larger step were:

• Inflation had been more persistent, the inflation outlook had deteriorated, and long-term inflation expectations had risen by some measures.
• The labour market was recovering strongly, unemployment was falling, and the outlook was for larger wage cost increases in the coming term.
• There was the risk that higher imported inflation would push domestic inflation further upwards.
• It was important to act decisively so as to minimise the risk that inflation would turn out even more persistent and inflation expectations would become unmoored from the target.

Many of these factors will still be relevant at this month’s meeting, although some of them – particularly those in favour of a smaller rate hike – are less applicable now.

Below is a summary of the factors that we believe the MPC will consider in connection with the next interest rate decision:

Further economic growth in the offing

Fluctuations in the pandemic and associated public health measures notwithstanding, the economy is chugging along at a good clip after the shock of 2020. In our recent macroeconomic forecast, we therefore project year-2022 GDP growth at 4.7%, on the heels of an estimated 4.1% in 2021. Exports will take over from domestic demand as the main driver of growth, but the outlook is for robust private consumption growth and modest growth in investment. We project GDP growth at 3.2% in 2023 and 2.6% in 2024.

Our forecast is in line with other recent forecasts, which also assume that GDP growth will be strong this year and ease thereafter.

Most indicators imply that economic activity will pick up significantly in coming quarters. Recent expectations surveys taken among households and businesses indicate a general sense of optimism about developments and prospects for the economy and the business community. Unemployment has plummeted in recent quarters and is now back to where it was a few months before the pandemic struck, and roughly 4 of every 10 executives consider themselves short-staffed, according to the Gallup survey carried out for the Confederation of Icelandic Employers and the CBI.

But there are certainly clouds on the horizon, not least for the tourism industry, which is the sector relied upon to deliver a large share of this year’s growth in export revenues and jobs. The tourism industry is in a delicate state after two years of limited, and volatile, revenue potential during the pandemic, and some firms in the sector will have difficulty absorbing a sudden rise in financing costs on top of everything else that has hit them. Doubtless the MPC will not want to put too many roadblocks in the way as Iceland’s largest export sector struggles to regain its footing. Furthermore, there is still some likelihood of setbacks in the pandemic, and therefore in tourist numbers, although in this regard the outlook has improved markedly in recent weeks.

Unfavourable developments in inflation …

The inflation outlook has deteriorated quite a bit since the MPC’s November meeting, and even then it was of considerable concern to Committee members. Inflation measured 5.7% in January, well above all published forecasts, and is now at its highest in nearly a decade.

The role of imported goods and house prices in the January measurement has attracted considerable attention, naturally enough, as both weighed heavily in the month-on-month rise in the CPI. But inflationary pressures are far more widespread than the past few days’ coverage indicates, as inflation excluding the housing component measures 3.7%. As the chart above indicates, all key components of the CPI are rising well in excess of the inflation target, although the housing component does stand out from the rest. So MPC members will no longer be able to take consolation in declining underlying inflation, as they did in November, as the core indices used by SI to measure underlying inflation have developed unfavourably since November.

Furthermore, high and swiftly rising inflation is far from a uniquely Icelandic phenomenon these days, and analysts the world over have had difficulty forecasting it, as we have here in Iceland. Inflation now measures 7.0% in the US, 5.1% in the eurozone, and 5.4% in the UK (as of December). But in most other economies, house prices are a far less prominent driver of inflation than they are here. On the other hand, there are factors such as household energy use, which has grown substantially in neighbouring countries, but fortunately, not in Iceland.

Inflation is therefore a global problem at the moment, and optimism about a rapid decline in coming quarters has grown considerably more muted recently. This also implies the risk that imported inflationary pressures will be more persistent in Iceland. Furthermore, this trend has radically changed interest rate expectations in many large economies. In coming quarters, this could 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 large-scale inflows of volatile capital for carry trade, or other side effects of a large interest rate spread.

… and a worsening inflation outlook …

In the CBI’s November forecast, which the MPC had ready to hand as it contemplated the last interest rate decision, inflation was projected to average 4.4% in Q1/2022 and then fall below the CBI’s target before the year-end. Since then, the inflation outlook has deteriorated rapidly, and in our preliminary forecast, prepared after the January CPI measurement, we assume that it will remain above 4%, the upper tolerance limit, for most of this year and not realign with the target until well into 2023. It is worth emphasising, though, that this is a preliminary forecast.

The most recent survey of market agents’ inflation expectations is along the same lines, but here it is well to remember that the survey was taken before the January CPI measurement was published. That measurement hardly gives market agents cause for optimism about the inflation outlook for the quarters ahead. It can be considered likely that the new inflation forecast from the CBI itself, which will be published concurrent with the interest rate decision, will sketch out a similarly dreary picture of the coming quarters, thereby dealing the MPC a considerably weaker hand than in November.

… play a role in rising long-term inflation expectations …

But the trend that could prove the biggest thorn in the MPC’s side is the rise in long-term inflation expectations, which can be seen in both the market expectations survey and the breakeven inflation rate in the bond market. According to the median response in the survey, market agents now expect inflation to average 3.0% over the next five years and 2.75% over the next ten. To be sure, these survey responses also capture high short-term inflation expectations to some extent, but even so, they should be something of a worry card for MPC members.

Much the same can be said of the breakeven inflation rate in the bond market, which has shot upwards recently. It should be borne in mind that some portion of the breakeven rate represents an uncertainty premium rather than actual expectations; furthermore, medium-term indexed bonds often benefit from rising short-term inflation, thereby boosting the medium-term breakeven rate, even if inflationary pressures are expected to be shorter in duration than the average lifetime of the bonds.

All that said, the breakeven rate is higher by some measures than it has been in nearly three years. It is currently 4.5% (five years) and 3.9% (seven years), after rising markedly since mid-2021. With all of these caveats, and allowing for the fact that the next few quarters’ inflation will affect estimates of average inflation a few years ahead, the MPC must be concerned about this trend.

… and dampen the impact of policy rate hikes on the real policy rate

Even though the policy rate has been raised by 1.25 percentage points since May 2020, the rise in the real policy rate has been much smaller by most measures. In this respect, rising inflation and inflation expectations pull in the opposite direction. Based on a simple average of recent measures, we calculate that the real policy rate is in the neighbourhood of -2.4%, whereas in November the same calculation gave a real rate of -2.1%. This is an extremely rough estimate, of course, but it does reflect the fact that at best, the November rate hike kept the real policy rate from falling even further in the recent term.

Bearing all of this in mind, there are strong grounds to argue that a fairly large rate hike is needed to push the real policy rate upwards, impede the rise in inflation expectations and, to quote the minutes from the MPC’s last meeting, “act decisively so as to minimise the risk that inflation [will] turn out even more persistent and inflation expectations [will] become unmoored from the target.” The key factors that might prevent the MPC from taking an even larger step than we forecast here are the aforementioned precautionary considerations about the impact on both household mortgages and business financing taken by vulnerable companies in tourism and other sectors hit hard by the pandemic.

Further policy rate hikes on the horizon

As before, we expect the CBI to continue on its monetary tightening path in the coming term, as the economy recovers and the effects of the pandemic taper off. Lower inflation further ahead should mitigate the need for rapid nominal interest rate hikes.

We expect rate hikes of at least 0.25 percentage points in each quarter for the rest of 2022, which would bring the policy rate to 3.5% by the year-end. If inflation proves even more stubborn than we expect, interest rates could be raised more quickly. Thereafter, we expect interest rates to rise gradually and, as before, we estimate that the monetary tightening phase will end at 4.0%, provided that the CBI ultimately wins the bout with inflation and that inflation falls to an acceptable level by late 2023.