We project that the Monetary Policy Committee (MPC) of the Central Bank (CBI) will decide to cut interest rates by 0.25 percentage points on 5 February, its next rate-setting date. The CBI’s key interest rate – the rate on seven-day term deposits – will therefore be 2.75% and will have fallen by 1.75 percentage points since May 2019. That said, there is a sizeable probability that the MPC will hold the policy rate unchanged this time, but if so, we expect a rate cut before mid-year.

At its last meeting, in December, the MPC voted unanimously to keep the policy rate unchanged. The Committee has been unanimous in its voting since mid-2019. Apparently, the possibility of a rate cut was not even discussed in December, and the forward guidance from the MPC was neutral.

In its rationale for keeping interest rates steady, the Committee noted, among other things, that it was appropriate to wait and see what the impact would be of measures already in place. Furthermore, the slack in the economy was relatively small, according to the CBI’s November forecast, although GDP growth was considerably weaker than before. The MPC also noted that, given the easing of the fiscal stance, less monetary easing would be needed than would otherwise be required; furthermore, interest rates were well below the estimated neutral real rate. Although underlying inflation had subsided in November, it was still above the inflation target.

Since the December decision, however, inflation has fallen steeply by all measures and is now at its lowest since autumn 2017. Furthermore, uncertainty about the economic outlook has shifted towards the downside in the recent term, although we share the CBI’s basic view, stated in November, that 2020 is most likely to see a gradual recovery. In our opinion, though, it is impossible to ignore the fact that the monetary stance has tightened, even though various factors indicate the need for a more accommodative stance than previously thought.

We therefore expect that this time, the arguments for a rate cut, shown here in the table, will outweigh the arguments for no change. That said, a rate cut could be deferred until the spring, but rates will very probably be lower at mid-year than they were at the beginning of 2020.

Gradual economic recovery in the offing

Although the economy appears set to fare better than previously expected after the export shocks of Q1/2019, available figures for the first three quarters of the year suggest clearly a shift towards a cooling phase. GDP growth measured 0.2% during the period. Domestic demand contracted by 0.9%, however, albeit offset by a favourable contribution from net trade.

According to our newly published macroeconomic forecast, the outlook for 2019 as a whole is for 0.3% GDP growth. A sharp contraction in business investment and services exports counterbalances consumption growth and a strong contraction in imports.

For 2020, we expect relatively slow growth of about 1.4%, driven by modest growth in domestic demand. We expect the economy to gain steam in 2021 and 2022, with growth measuring 2.3% and 2.4%, respectively, as private consumption and exports regain momentum.

Last year, however, there was also an abrupt turnaround in the labour market. Unemployment rose by about a percentage point of the labour force, and wage rises were the smallest since 2010. WOW Air’s collapse and the contraction in tourism are important factors in this about-face, together with streamlining in the banking system and elsewhere.

Even though the signing of the so-called standard of living agreement was positive overall, there is still some uncertainty in the labour market, as public sector wage agreements are still pending. We expect unemployment to peak next year at 4.4% and then fall to 3.0% in 2022. We also expect real wage growth to measure about 2.0% per year through 2022.

The CBI’s last macroeconomic forecast, published in November, was somewhat more upbeat than our own most recent one. The CBI projected GDP growth at 1.6% this year and 2.9% in 2021. The CBI will issue a new forecast concurrent with next week’s policy rate decision, and a downward revision of output growth would come as no surprise.

Inflation expectations at target

The disinflation that followed the brief inflation spike in late 2018 has continued unabated. Inflation now measures 1.7%, down from 3.7% just over a year ago, and is now at its lowest since September 2017. This disinflation episode is due primarily to the slowdown in house price inflation, dwindling exchange rate pass-through from the 2018 ISK depreciation to imported goods prices, and reduced price pressures from domestic goods.

The outlook is for moderate inflation in the coming term. We expect inflation to remain below the CBI’s target this year, averaging 2.2%, before rising to an average of 2.6% in 2021 and 2.7% in 2022. In November, the CBI projected H1/2020 inflation at 2.4%, and we expect a downward revision in the upcoming Monetary Bulletin. On the other hand, the bank’s November forecast was noticeably optimistic about inflation from mid-2020 through end-2022, and we expect no material change there.

Inflation expectations and the breakeven inflation rate have fallen in tandem with declining inflation. It is particularly positive to see how quickly long-term inflation expectations and the long-term breakeven rate in the market have fallen back to the target in the past year. Indeed, we expect the MPC to view this development with satisfaction. Both the breakeven rate and inflation expectations are well in line with the CBI’s inflation target — in fact, given that the breakeven rate also includes an uncertainty premium, it is actually somewhat below target.

In December, the MPC noted that underlying inflation was still somewhat above target, according to figures for November. As a result, it is noteworthy that according to Statistics Iceland’s (SI) core inflation indices, it has fallen faster, if anything, than CPI inflation.

Higher real rate unnecessary in the current environment

The CBI has lowered the policy rate by 1.5 percentage points since spring 2019. However, the real policy rate, which reflects the monetary stance, has fallen much less, owing to declining inflation and inflation expectations. According to various measures, the real policy rate ranges between 0.5% and 1.3% in the most recent measurements, whereas in April 2019 (just before the monetary easing phase began) it lay in the 0.5-1.2% range.

In December, the MPC noted that policy rate cuts had delivered lower interest rates for households but that the spread between the policy rate and corporate lending rates had widened and new lending to businesses had continued to lost pace. MPC members did not want to react too strongly to this last development but thought it appropriate to keep an eye on the situation.

The most recent corporate lending figures should have some impact on the Committee, then, as lending growth has slowed still further. Moreover, the ISK value of corporate loans declined by 1.7% in real terms in 2019.

Long-term real rates in the market rose somewhat following the November rate cut, after a marked decline, but they have fallen again since the beginning of December. Long-term real rates are still about the same as in mid-2019, however, measuring 0.8% at the close of business on 30 January. A simple average of various measures of the real policy rate tell a similar tale, indicating that the monetary stance is about the same as in July 2019.

Has the policy rate bottomed out?

After the next rate cut, we expect the policy rate to remain flat through the year-end. This will leave it at 2.75% in the beginning of 2021. Thereafter, we expect a gradual increase alongside improvements in the economic outlook and rising inflation, although we also expect inflation to remain close to target through end-2022. The uncertainty in this forecast is concentrated on the downside, in that short-term interest rates could fall further and remain low for a longer period, particularly if tourism-related risks materialise to any significant degree. No least among these risks is the possible effect of the coronavirus epidemic in China on global tourism and demand, although it is far more likely that the impact will be limited.

In our opinion, however, further policy rate cuts will do limited good by themselves; they must be accompanied by easing of macroprudential tools and other financial system policy instruments that make it difficult for firms (smaller ones in particular) and households to obtain credit financing on acceptable terms. Among these tools are stiff capital and liquidity ratio requirements, a heavy tax burden, and a cumbersome internal and external regulatory framework that, as many have pointed out, increases costs considerably.