In October, all MPC members agreed to raise the CBI’s policy rate by 0.25 percentage points. It was the first time since May that all members voted unanimously in favour of the Governor’s proposal.

According to the minutes from the October meeting, MPC members were of the opinion that there were grounds to either hold the key rate unchanged or raise it by 0.25-0.5 percentage points. This represented something of a sea change from the August decision, which was based on a more or less unequivocal conviction that a rate hike was in order.

The MPC’s main arguments in favour of leaving the policy rate unchanged were as follows:

• Inflation had been lower than expected in the recent term.
• The short-term inflation outlook had improved.
• Inflation expectations had fallen by some measures.
• The Bank’s real rate had therefore risen between meetings and looked set to rise further if inflation continued to fall.
• Clear signs had emerged to indicate that the Bank’s actions had begun to affect demand, as housing market activity and house price inflation had started to ease.
• Tensions in the labour market also appeared to have eased in the recent term.
• Furthermore, private consumption growth could be expected to lose pace, all else being equal, as real wages had begun to contract.
• The global economic outlook was worse than expected, particularly in view of the rising cost of living in Europe and the troubled outlook for energy supply, which could have a detrimental impact on the outlook for Iceland’s exports.

The MPC’s key arguments for a rate hike in October were these:

• Although inflation had fallen between meetings, it was still far above the target.
• Underlying inflation had risen.
• Long-term inflation expectations were above the target.
• The inflation outlook in trading partner countries had deteriorated, and there was the risk that second-round effects on domestic inflation would increase accordingly if firms passed higher input costs through to domestic prices.
• Annual wage inflation had been strong for some time, and in the MPC’s opinion, the labour market was still tight and domestic demand strong.
• As a result, the monetary stance was not tight enough given the business cycle position and the output gap, as the Bank’s real rate was still negative and below its equilibrium level.
• It was important to avoid easing the policy stance too soon, as this could make bringing inflation down costlier than it would be otherwise.

Below is a summary of the factors that will probably affect the MPC’s November decision.

Demand growth is resilient, but an adjustment is in the offing

The Icelandic economy has been humming along at a good clip in recent quarters and, in many ways, shows signs of an output gap rather than a slack. Output growth measured 6.8% in H1 and was driven primarily by strong growth in private consumption and services exports, supported by a solid increase in investment.

In our macroeconomic forecast from September, we projected output growth at just over 7% for 2022 as a whole. That forecast still appears quite close to the mark. That said, it looks as though the composition of growth in H2 will be somewhat different than we had expected, with domestic demand playing a bigger role and import growth correspondingly stronger. Indicators such as payment card turnover, overseas travel, motor vehicle registrations, and imports suggest that growth in private consumption and investment was brisk in Q3. In October, for instance, Icelanders set a new single-month record for overseas travel.

There are no signs as yet that the erosion of real wages has begun to affect Icelanders’ consumption behaviour – and actually, it is debatable whether real wages have indeed fallen, as we have discussed recently. The economy therefore appears to be moving more slowly towards equilibrium after the recent growth spurt than we had anticipated, and the effects of policy rate hikes on domestic demand seem to be coming later to the fore than the MPC was probably hoping earlier this autumn.

Developments in the labour market tell a similar tale. Unemployment according to Directorate of Labour (DoL) data measured 2.8% in October, its lowest since year-end 2018. In Q3, workers were needed to fill an average of about 3.6% of jobs in the economy, according to a Statistics Iceland survey, and in September, executives from just over half of Iceland’s largest firms considered themselves understaffed. Wage agreements affecting most of the private sector expired at the end of October, and most indicators suggest that the upcoming round of negotiations will be contentious, owing to demands from the labour movement for hefty pay rises.

That said, recent economic forecasts have accorded with our opinion that the economic growth will slow considerably in the next two years or so. Reduced tension in the economy and the labour market should make it easier for the CBI to contain demand growth and foster an environment in which excess demand for goods, services, and labour is less likely to push prices upwards.

Disinflation hits a bump in the road

Inflation has started to taper off after the surge of the past several quarters, peaking at 9.9% in July and then subsiding in Q3. In October, though, it ticked upwards unexpectedly to 9.4%. Inflation is quite widespread these days, too, even though recent discussions have been dominated by house prices and imported goods prices. For example, all measures of underlying inflation and most subcomponents of Statistics Iceland’s (SI) inflation measurements have risen by more than 5% in the past twelve months – twice the CBI’s inflation target.

House prices turned a corner in mid-year, and there are numerous signs that the market is starting to settle down. It remains tight, however, and the jump in house prices in recent measurements may well have come as a surprise to the MPC, as it did to us. As a result, it is impossible to say with certainty that house prices will have a countervailing effect on inflation in coming months, although they are expected to do so further ahead.

Nor has the ISK been helpful in defusing short-term inflation in the recent past. Since the last policy rate decision, it has depreciated by almost 4% in terms of the trade-weighted exchange rate index (TWI) the start of this week saw the ISK at its weakest by that measure since March 2021. There are various reasons for this: Icelanders’ aforementioned zest for consumption and investment, unfavourable developments in relative import and export prices, increased foreign currency purchases by pension funds, and possibly a shift in some corporate debt from FX loans to ISK-denominated loans. In any case, all of these trends will smudge the near-term inflation outlook if they do not reverse – not to mention the effect that the ISK will have if it depreciate further in the months to come.

The outlook is for inflation to remain well above the CBI’s 2.5% target in the coming term. The longer that situation persists, the greater the risk that long-term inflation expectations will become entrenched at levels out of sync with the target.

Inflation expectations still on the high side

As is to be expected, the MPC has paid close attention to movements in long-term inflation expectations when taking interest rate decisions in the recent past. As recently as last month, in the rationale for its October decision, the MPC made reference to the fact that expectations had fallen by some measures. But neither recent expectations surveys nor developments in the breakeven inflation rate in the bond market give much cause for celebration these days.

By all measures, inflation expectations are far above the CBI’s target. It is worth remembering, though, that high inflation in the next few quarters will doubtless affect survey respondents’ expectations about average inflation over the next five years. For example, if a survey participant expects inflation to average 3.2% over the next five years, this could reflect the expectation that inflation will measure 6% during the coming year and 2.5% over the four years thereafter. On the other hand, certain measures reflect higher long-term inflation expectations than can be explained by a near-term spike followed by target-level inflation. An example of this is the implied five-year breakeven rate five years ahead – i.e., the ten-year breakeven rate in the bond market, after adjusting for the first half of that period. As the chart shows, this breakeven rate is a full percentage point above the inflation target and has been inching upwards recently.

The breakeven inflation rate always includes an uncertainty premium, however, as real yields on nominal Treasury bonds are unknown, while indexed bonds guarantee real returns in line with the market yield on the date of purchase throughout the lifetime of the bond. It is not impossible, then, that a sizeable share of the current deviation in the breakeven rate from target is due to such uncertainty. Nevertheless, a high breakeven rate – not to mention the recent increase – must be a burr in the saddle of the MPC, which cited declining inflation expectations as one of the arguments in favour of a modest policy rate hike in October.

Real policy rate on the rise

The CBI’s real policy rate has risen by all measures recently: nominal interest rates are up significantly in 2022 to date, inflation has eased since mid-year, and inflation expectations have held steady by most measures, or at least risen more slowly than nominal interest rates have. The real policy rate is above zero by nearly all forward-looking measures, generally ranging between 0.5% and 1.2%. But this is not terribly high, given that there are still broad-based demand pressures in the economy at a time when long-term inflation expectations are higher than the CBI would like them to be. The CBI will presumably want to see the real policy rate rise a bit higher by as many measures as possible, and sooner rather than later.

We are of the view that the MPC will not want to be overly harsh in expressing the need for further monetary tightening, and that the forward guidance in next week’s statement will therefore be relatively neutral, as in October. Whether the Committee then stops raising rates or considers it necessary to push them higher later this winter will depend on how inflation and the economic outlook develop in the next few months. If our forecasts of developments in the economy, the business community, the housing market, and inflation prove reasonably accurate, we believe the CBI will decide to leave well enough alone and hold the policy rate unchanged at 6.0% until mid-2023. A slow and gradual monetary easing phase will then take over as the economy cools and inflation subsides.

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