The MPC reached a split decision on the policy rate in March, as it did in February. One of its five members would have preferred to lower the policy rate by 0.25 percentage points, but the other four voted to keep it unchanged. The MPC’s main grounds for its March decision were as follows:

• Inflation and inflation expectations were still high.
• Although growth in domestic demand had slowed in the recent term, indicators implied that it remained strong.
• Firms had scaled their hiring plans upwards again, the share of firms reporting staffing shortages was still high, the labour market was still tight, and unemployment was low.
• Housing market activity was still strong, and house prices had risen in the recent term.
• There was a reasonable probability that 2023 GDP growth had been underestimated in the most recent data, as previous figures had been revised substantially and the newest figures should therefore be interpreted with caution.
• Even though the recent signing of long-term wage agreements was a positive development, there was some risk that firms would pass a large share of the wage hikes through to prices, as had happened at the beginning of 2023.
• It was not yet clear how fiscal measures would be financed, what impact they would have on demand, and whether the fiscal stance would ease.
• A high real rate was still needed to ensure that inflation would not remain persistent for a protracted period of time.
• The risk that the monetary stance was too loose to bring inflation back to target within an acceptable time frame was still greater than the risk that it was too tight.

Gunnar Jakobsson’s rationale for casting the dissenting vote to lower the policy rate was as follows:

• The situation was similar in most respects to that prevailing at the beginning of February, but uncertainty had diminished because of the signing of benchmark-setting private sector wage agreements.
• The real rate had continued to rise rapidly, and households’ and businesses’ situation had tightened.
• The effects of previous interest rate hikes had yet to emerge.
• In view of the current situation and the data available to the Committee, it was appropriate to begin lowering the policy rate incrementally.

Below is an overview of various factors the MPC will probably consider at the May rate-setting meeting:

Economic indicators: A tale of two economies?

In some respects, recent statistics are ambiguous about the current state of the economy and the near-term outlook. On the one hand, the national accounts and related indicators suggest that the economy is cooling relatively swiftly. National expenditure, which reflects domestic demand, shrank by over 1% in H2/2023, and the pace of GDP growth screeched nearly to a halt during the year, tumbling from almost 9% in Q1 to less than 1% in Q4. Furthermore, data on payment card turnover, new motor vehicle registrations, overseas travel, and imports of consumer and investment goods indicate a contraction in private consumption, and at least some types of investment, in Q1/2024.

CBI officials have repeatedly discussed – and, in our opinion, perhaps overemphasised – the strong accumulated GDP growth in 2021-2023. It is worth noting, though, that this growth is partly a manifestation of the recovery from the steep contraction in 2019, and the effects of strong growth 1-3 years ago have already emerged in other metrics that the Committee takes into account. In addition, Statistics Iceland’s (SI) revised GDP growth figures better illustrate recent inflationary pressures and market tensions than previous figures did, without necessarily adding much to the story. For example, there is now greater consistency between total hours worked and growth than with previous figures, and labour productivity therefore measures considerably higher during the period than it did before.

On the other hand, the housing and labour markets are undeniably strong. Unemployment remains low, and labour demand is robust. For example, executives from over a third of Iceland’s largest companies considered themselves understaffed in Q1/2024, and three of every ten planned to hire workers in coming quarters. Both of these ratios had risen somewhat between measures.

The new private sector wage agreements were positive overall for the inflation outlook, as they were long-term contracts that included relatively modest percentage pay rises for a large share of workers. On the other hand, it is still quite uncertain how much the Government’s involvement in the contracts will cost in the form of a more relaxed fiscal stance, not to mention that a portion of the private sector and a large share of the public sector have yet to finalise new wage agreements. It could well be that the MPC will want to gain a better view of both the overall results of wage negotiations and the initial impact of the contracts on inflationary pressures before it responds with interest rate cuts.

House price inflation has picked up again in recent months, and demand for housing appears strong despite high mortgage rates and tighter borrowing requirements. House prices nationwide rose by over 6% year-on-year in Q1/2024, according to SI’s most recent measurement, up from the recent trough of about 2% six months ago. Furthermore, housing market activity has picked up again noticeably in the past few months, according to the Housing and Construction Authority’s (HMS) most recent monthly report. The HMS is of the opinion that part of this activity is related to the Government measures to assist Grindavík residents.

As is noted above, the MPC expressed concerns in March about the stubbornness of the housing and labour markets, and the most recent data are hardly likely to assuage that uneasiness.

Inflation is falling, but expectations are high

Doubtless it came as a relief to many when inflation forecasts for April were borne out and headline inflation fell from 6.8% to 6.0%, its lowest in two years. All measures of underlying inflation declined as well. We are of the view that further disinflation is in the offing, as we have discussed recently. According to our preliminary forecast, inflation will ease to 5.5% in June, fall below 5% by the year-end, and measure around 3% from mid-2025 onwards.

The CBI will publish a new inflation forecast in Monetary Bulletin, concurrent with the May interest rate decision. It will be interesting to see whether the inflation outlook depicted in that forecast will be similar to the one in our own preliminary forecast, and whether MPC members consider the outlook favourable enough that they can begin considering cutting interest rates.

In this context, it is worth repeating this excerpt from the minutes from the MPC’s March meeting:

“Unambiguous indications that inflation was clearly on the decline would have to emerge in order to make it possible to lower interest rates, and it was important to begin the monetary easing phase at a credible point in time.”

On the question of whether developments meet these criteria as stated by the MPC majority, it is possible to argue for and against, and the CBI’s forthcoming inflation forecast could make a big difference in how the scales tip.

Although inflation itself is on the decline, the MPC is understandably concerned that inflation expectations should still appear so high by various measures. The breakeven inflation rate in the bond market has risen since the beginning of March, for instance, although some of the increase has reversed in the past few days.

By the same token, households’, businesses’, and financial market agents’ long-term inflation expectations are still high, although in the case of households and businesses they have receded somewhat from their recent peaks. New measurements of market agents’ inflation expectations will probably hit MPC members’ desks before the May interest rate decision, but for households’ and businesses’ expectations, the MPC will probably have to rely on data from Q1.

On the other hand, one characteristic of untethered inflation expectations is that they fluctuate more with short-term inflation and the near-term inflation outlook than would be the case if inflation expectations were well anchored. As a result, it is not unlikely that the newest measures of expectations will be more favourable, given the drop in twelve-month inflation this April. Based on the data currently available, though, it can be assumed that MPC members will view measures of expected inflation as grounds for unchanged interest rates rather than as support for a rate cut.

The highest real interest rate in donkey’s years

Although the tussle with inflation expectations is only going moderately well for the MPC, the CBI has been more successful in pushing short- and long-term real rates upwards. For example, in terms of a simple average of measures of expected inflation, the real policy rate is closing in on 4%, its highest since the beginning of the 2010s. As the chart shows, the real policy rate was considerably negative from the onset of the pandemic until autumn 2022. It has therefore risen by 6-7% in the past two years in terms of the above-mentioned average, reflecting an about-face in the monetary stance.

Long-term real rates in terms of bond market yields have also risen significantly in the recent term. For example, the yield on ten-year Treasury bonds was right around 0.5% two years ago but has averaged nearly 2.7% this April.

Whether this is adequate will depend on CBI officials’ assessment of the necessary monetary stance in view of the state of the economy and the deviation of inflation and inflation expectations from target. It is worth mentioning that according to the CBI’s quarterly macroeconomic model, QMM, a neutral real policy rate has been set at around 1.3% in recent years. Presumably, though, the MPC will take a view similar to ours, that just as in other countries, the equilibrium real rate has probably risen in the recent past, after falling virtually unimpeded in the decades beforehand.

Interest rates will fall … in the end

Given the developments of the past few months, and in view of the MPC’s recent focus, we have revised our long-term policy rate forecast somewhat. We expect the monetary easing phase to occur later than we had previously forecast, and we project that the policy rate path will be higher than, for instance, in our macroeconomic forecast from late January.

Nevertheless, we still think a rate cut is in the cards before the year-end and that the easing process will continue in coming years. If our inflation and economic forecast materialises, we expect monetary easing to start with a rate cut of 0.25 percentage points in Q3, when there is only one interest rate decision date – 21 August – on the CBI’s calendar. In Q4, there are two rate-setting dates on the calendar, and we expect a rate cut of at least 0.25 percentage points more during that quarter. This would bring the policy rate to 8.75% at the year-end.

In coming years, we expect the easing cycle to continue in response to declining inflation and a cooling economy. The policy rate could therefore be down to 6.0-6.5% by year-end 2025 and 5% by H2/2026. Naturally, the uncertainty in these projections increases further out the horizon, and if the past few years have taught us anything, it is that circumstances at home and abroad can change in the blink of an eye.

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