In August, the bank’s Monetary Policy Committee (MPC) voted unanimously in favour of Governor Ásgeir Jónsson’s proposed 0.75-point rate hike. One member, Gylfi Zoëga, would have preferred to raise rates by 1 percentage point but acceded to the Governor’s proposal. Rate increases ranging from 0.5-1.0 points were discussed by the Committee, but with the above-mentioned exception, members appeared to have settled on the 0.75-point rate hike.

Key arguments for a sizeable rate hike:

• Domestic demand had proven stronger than the MPC had anticipated, and there was clearly considerable momentum in the economy.
• There were signs that private consumption had grown considerably more than the Committee had assumed, and it appeared that households were drawing down their savings more quickly than previously estimated.
• The tourism industry was recovering more rapidly than previously expected.
• All measures suggested that the labour market had tightened significantly.
• The inflation outlook had continued to deteriorate.
• Inflation expectations had continued to rise, which could exacerbate the risk that companies, prompted by strong demand and recent wage and input cost increases, would pass these costs through to prices to a greater extent.
• It was vital to give increased weight to how rapidly tensions in the labour market had grown, and to the clear signs of overheating in the economy.
• If the monetary stance were not tightened fast enough, high inflation would be more likely to become entrenched and it would be more difficult to bring it back to target.

Key arguments for a smaller rate hike:

• The rapid increase in the key rate in the recent term had begun to have an effect, including on the housing market, and the full impact had not yet come to the fore.
• Steep cost of living increases and the prospect of reduced purchasing power could cause the economic outlook to reverse.
• The global economic outlook had continued to deteriorate between meetings, potentially affecting the outlook for Iceland’s exports.
• In many regions, households and businesses were at their most pessimistic ever about economic prospects.
• Global oil and commodity prices had fallen in the recent term, reducing inflationary pressures.

Many of these considerations still apply on both sides of the equation. That said, the inflation outlook has improved, and inflation expectations have eased downwards since the August interest rate decision. Furthermore, the global economic outlook has grown still bleaker, particularly in the UK, but also in mainland Europe. On the other hand, it is worth noting that Iceland’s interest rate differential with abroad has narrowed considerably in recent weeks, after a significant repricing of foreign interest rates in most of the world’s major currencies.

Booming GDP growth in 2022, but with much slower growth in the cards

The Icelandic economy has been buoyant in the recent term. In our recent macroeconomic forecast, we reviewed developments and prospects for the domestic economy and projected 2022 output growth at 7.3%, Iceland’s strongest growth rate since 2007. Growth is driven both by domestic demand, particularly in H1, and exports, which will be the mainstay of growth in H2.

For 2023, we forecast GDP growth at 2.2%. It will be buoyed up largely by exports, as domestic demand growth will slow significantly year-on-year. We forecast output growth at 2.4% in 2024. By then, export growth will have subsided and consumption and investment will have started picking up again.

The economy is showing numerous signs of operating at or above capacity at present. Private consumption has grown rapidly, and the labour market is characterised by a shortage of labour rather than of jobs. One manifestation of the current economic situation is surging house prices, although the pace of house price inflation looks set to ease significantly in the quarters to come.

Inflation set to ease relatively quickly in the coming term

The inflation outlook has brightened a bit after a protracted period of ever-rising prices. Headline inflation measured 9.3% in September, and imputed rent (a metric that largely reflects house prices) made the news by rising only 0.05%, the slowest pace recorded since November 2020.

Inflation looks set to taper off steadily in coming quarters as house price inflation loses steam and imported inflation stabilises. We expect it to have fallen to just over 5% by this time next year. Further disinflation is likely to follow, and our long-term forecast provides for an inflation rate of just over 3% in two years’ time.

In August, the CBI forecast that inflation would peak at nearly 11% in Q4/2022 and then subside at a brisk pace over the course of 2023. It now appears, however, that that the bank’s projections for H2/2022 were overly pessimistic, and it must come as a relief to the MPC that the inflation outlook has improved.

Breakeven inflation rate turns a corner

After rising steeply early in the year, the breakeven inflation rate in the bond market has fallen once again. The three-year breakeven rate has hovered around 4.3% recently, down from 4.5% at the time of the MPC’s last interest rate decision. The longer-term breakeven rate has fallen as well, and our calculations suggest that the five-year breakeven rate five years ahead – a metric CBI officials pay close attention to – has fallen from 4.2% to 3.6% over the same period.

It is still well above the inflation target by all measures, of course, but two things should be borne in mind: first, the breakeven inflation rate includes a risk premium reflecting uncertainty about long-term nominal rates; and second, high inflation in coming quarters will affect the average for the next few years, even if inflation returns to acceptable levels reasonably soon. At all events, the recent decline in the breakeven rate should give the MPC cause for cheer.

Real policy rate on the rise

The real policy rate is still low by all measures, and negative by some of them. The CBI signalled clearly in August that it expected to have to tighten the monetary stance still further in the short run so as to bring inflation and inflation expectations under wraps and nudge the real policy rate upwards.

Inflation and inflation expectations have eased since the CBI’s August interest rate decision, however, and this, plus the August rate hike itself, has pushed the real policy rate upwards by those measures. It is worth noting that one metric often used to estimate the real policy rate – comparing twelve-month trailing inflation and the CBI’s key rate – gives a misleading indication of the monetary stance when inflation is expected to fall, as it compares past inflation to an interest rate whose impact lies in the future.

In essence, then, the monetary stance is not as accommodative as this particular metric might indicate. A continued decline in inflation expectations and the breakeven inflation rate will tend to tighten the monetary stance even if measured inflation remains high for a while.

Tightening phase coming to a close?

We forecast that the policy rate will be held steady after October and will end the year at 6%. Assuming that inflation and demand pressures have indeed begun to ease, we expect the policy rate to remain unchanged until mid-2023 and then start to fall again in the second half of that year. Thereafter, we expect gradual easing towards the equilibrium real rate, which is probably 1-1.5%. The nominal policy rate could therefore be in the neighbourhood of 4.5% two years from now, although uncertainty is naturally greater further out the horizon.

Yield curves in the market suggest that a further policy rate hike has already been priced into long-term rates. Long-term base rates are now just over 6% in terms Treasury bond yields, but 1.8-2.0% in terms of real rates on indexed Treasury bonds. Long-term rates have risen markedly in 2022 to date, in the wake of policy rate hikes.

Assuming that the policy rate develops in line with our forecast, we think the rise in long-term rates has largely come to the fore. When the policy rate has peaked and an easing phase is in sight, we expect long-term rates to start inching downwards. By the end of the forecast horizon, we expect the policy rate to approach equilibrium, which we estimate at around 4.5% for nominal rates and somewhere near 1.3% for the real rate.