Uncertainty about the recent collapse of the Government coalition and the prospect of Parliamentary elections, plus the ongoing strikes affecting a sizeable group of public sector workers, will probably prompt the Committee to exercise greater caution about next week’s decision, however. Furthermore, the MPC must weigh the recent disinflation episode, the cooling housing market, and the brightening inflation outlook against resilient private consumption, a still-tight labour market, and overly high inflation expectations.

At the beginning of October, the PSN launched its long-awaited monetary easing phase with a rate cut of 0.25 percentage points. Until then, the policy rate had been held steady at 9.25% for over a year. There was a stronger consensus behind the October rate cut than many had expected. One MPC member, Herdís Steingrímsdóttir, stated for the record that she would have preferred to leave the policy rate unchanged, but in the end, the proposed rate cut was approved unanimously.

According to the minutes from the October meeting, the main arguments in favour of a rate cut were as follows:

• Members agreed that various indicators suggested that growth in economic activity had continued to taper off.
• Inflation had fallen more than anticipated, the contribution of domestic goods and services to inflation had eased, and price increases were less widespread than before.
• Inflation expectations had fallen by some measures.
• Although labour demand was still strong, there were clear signs of a slowdown, as job growth had lost pace and registered unemployment had continued to inch upwards.
• Staff shortages had apparently subsided, firms had scaled down their staff recruitment plans, and the share of companies operating at full capacity had fallen.
• The recent increase in the commercial banks’ indexed mortgage rates and structural changes in the credit market that had caused borrowing terms to tighten could lead to a more rapid downturn in lending growth than would otherwise be seen
• This could result in a more rapid decline in housing market activity, whereas the rise in the housing component of the CPI still accounted for a large share of headline inflation.
• Overall economic activity could lose pace quickly in 2025.
• Many factors had therefore moved in the right direction in the recent term, and the impact of high real interest rates was clearly visible.

There were various arguments for leaving the key interest rate unchanged, however:

• About half of the recent drop in inflation was due to one-off items, and underlying inflationary pressures were still present.
• It was not clear that underlying inflationary pressures had tapered off decisively between meetings.
• Domestic demand remained strong, the real estate market was still robust, and payment card turnover figures suggested that demand had picked up in Q3, as previous wage increases were still supporting demand.
• It therefore appeared that underlying demand pressures remained in the economy.
• Households’ position was strong overall, as could be seen in a high saving rate and strong growth in deposits.
• Under these circumstances, Government transfers to households could stimulate demand.
• Even if inflation continued to fall in the near term, it could then plateau at a level somewhat above target; therefore, it was important to maintain a tight monetary stance further ahead.
• Although the newly introduced fiscal budget proposal provided for a more or less neutral fiscal stance in 2025, it had yet to be discussed in Parliament.

The MPC concluded that on the whole, growth in economic activity had eased steadily since 2023. The Committee agreed that the monetary stance had tightened in the recent term, particularly in view of the fact that transmission to long-term real rates had grown more effective. In addition, it was likely that the stance would tighten further in the coming term. In light of this, it would be possible to lower nominal interest rates cautiously, while still maintaining an appropriate monetary stance.

Presumably, many of these factors will be in the MPC’s crosshairs again at the November meeting. We expect the Committee to discuss the following points at the upcoming meeting:

The economy is cooling

Most indicators imply that economic activity lost steam during the autumn, as the MPC noted in early October. Demand is still fairly resilient, however. For example, domestic payment card turnover grew in real terms by 2.6% year-on-year in Q3. The Gallup Consumer Confidence Index took a hefty leap following the CBI’s October rate cut, perhaps signalling that consumption spending will do likewise in the final months of the year. On the other hand, households’ new motor vehicle purchases have contracted sharply in 2024 to date, suggesting that high interest rates are prompting them to shy away from incurring debt in order to purchase consumer durables such as cars. In fact, the contraction in car purchases explains the lion’s share of the difference year-to-date between developments in card turnover, on the one hand, and private consumption, on the other.

Nonetheless, signs of cooling are widespread. Labour shortages have eased, large companies have scaled down their hiring plans, and unemployment inched upwards during the autumn, although the labour market is still relatively strong and firms’ staffing levels have not contracted severely. This can be seen, for instance, in the lack of announced collective redundancies since the end of summer. In addition, wage rises have lost pace considerably, although real wages have risen slightly YoY, owing to the even more rapid drop in inflation.

Tension in the real estate market appears to be easing as well. According to recent figures from the Housing and Construction Authority (HMS), the house price index dipped slightly between August and September. It was the first month-on-month decline since January of this year. The same is true of the rent price index, which fell in September for the second month in a row, according to HMS data. In real terms, though, both indices have risen YoY. Furthermore, the HMS’ monthly report for October suggests that demand pressures are subsiding in the housing and rental markets.

Recent macroeconomic forecasts have been broadly in line with our own end-September forecast, wherein we projected that 2024 would be a year of adjustment with negligible output growth. Statistics Iceland, (SI) in its most recent forecast, projects 0.1% GDP growth this year, and the International Monetary Fund (IMF) forecasts it at 0.6%. Our output growth forecast of 0.3% for 2024 lies more or less in the middle. Forecasts for 2025 diverge more widely, with SI and the IMF projecting growth at 2.4%, as against our forecast of 1.2% growth. Recent indicators of exports – such as the bleaker outlook for the capelin season, energy rationing to heavy users in the energy-intensive sector, and a reduction in seat availability on flights to Iceland – support us in our opinion that GDP growth will be fairly weak in 2025. In its August forecast, the CBI projected GDP growth at 0.5% in 2024 and 2.0% in 2025. It will be interesting to see how the CBI’s view of the near-term economic outlook is depicted in the November Monetary Bulletin.

The inflation outlook has improved

Inflation has declined markedly since the beginning of August, falling from 6.3% in July to 5.1% by October. Underlying inflation is also down sharply by all measures and, by some of them, was close to target in October, as the chart illustrates. The outlook is for inflation to fall below 5% in November and keep declining steadily until mid-2025. Thereafter, we forecast that on average, it will be only a hair’s breadth away from the CBI’s inflation target We can in fact say that according to our forecast, inflation will be broadly at target in H2/2025 and H1/2026.

In August, the CBI projected that inflation would average just over 6% in H2/2024 and would not fall below the upper deviation threshold of the target (4%) until Q3/2025. Based on our most recent inflation forecast, inflation will average 5.4% in H2 and break the 4% barrier in February 2025. It will be interesting to see the CBI’s new inflation forecast, set for publication concurrent with the November policy rate decision. We expect that forecast to sketch out a cheerier picture of the inflation outlook than we saw in August.

… but high inflation expectations are still a problem

The long-term breakeven inflation rate in the bond market has hardly budged since the October policy rate decision. In Q3, however, it fell by all measures. The short-term breakeven rate fluctuated widely in October, largely because of changed expectations about the impact the new motor vehicle tax structure would have on the CPI when it takes effect in January. We have recently explored that situation  in greater detail.

The breakeven inflation rate in the bond market is still uncomfortably high, and the MPC has repeatedly voiced concerns about it in the context of recent interest rate decisions. As of this writing, the two- and five-year breakeven rate is 3.8%, while the ten-year rate is 3.9%. There are more factors at work than inflation expectations alone, however, and some indicators suggest that market inflation expectations have been lower recently than the breakeven inflation rate would imply.

Just like the breakeven rate, long-term inflation expectations have remained persistently high and, naturally enough, have been a burr in the MPC’s saddle. Unlike its counterparts in neighbouring countries, the CBI is not supported by favourable long-term expectations in its bid to bring inflation back to target. If inflation expectations remain high over time, there is a greater risk that sellers of goods and services will raise prices more rapidly than they would otherwise, and that workers will demand larger nominal pay hikes than would be consistent with low and stable inflation.

The recently released results from the Central Bank’s survey on market participants' expectations reveal a significant decrease in inflation expectations for both short- and long-term horizons. One-year inflation expectations have declined from 4.3% to 3.5%, and two-year expectations have dropped from 4.0% to 3.4%. Notably, the assessment is further weighted by a reduction in five-year average inflation expectations from 3.8% to 3.3% and ten-year expectations from 3.6% to 3.0%. This data suggests that implied five-year inflation expectations after five years—a key metric for Central Bank assessments—are now only marginally above the 2.5% inflation target.

It will be very interesting to see whether long-term expectations taper off as the winter advances and headline inflation moves closer to the CBI’s target.

Real interest rates are up by all measures

Real interest rates have risen steeply by all measures in the recent term and are noticeably high by most of them. In terms of the simple average of all measures of expected one-year inflation, the Central Bank’s real rate was 4.3% in September. It was only two years ago, however, that the real rate by this measure entered positive territory for the first time since early in the pandemic. The real policy rate in terms of past twelve-month inflation has developed in a broadly similar way. By that measure, the real rate was 3.7% in October, but as the chart shows, only five quarters have passed since the policy rate caught up with inflation.

Long-term real rates have also risen markedly in the recent term. For instance, the real rate in terms of the yield on ten-year indexed Treasury bonds was just over 2.7% in October, after having been below 1% from the onset of the pandemic until mid-2022. Furthermore, indexed mortgage lending rates have risen steadily in recent quarters, and the MPC stated outright in the minutes from its October meeting that this increase had been a factor in its policy rate decision.

Presumably, the MPC will want to keep the real rate relatively high while inflation and inflation expectations remain well above the CBI’s target. Nonetheless, a cooling economy, declining inflation, and – hopefully – falling inflation expectations should afford the Committee the scope to gradually unwind the monetary stance as reflected in short- and long-term real interest rates.

Sizeable policy rate reduction on the horizon

If economic and inflation developments play out as we expect, the MPC should be able to continue lowering the policy rate in coming quarters. The outlook is for demand pressures in the economy – and therefore the need for a high real rate – to recede concurrent with the expected drop in headline inflation. Hopefully, inflation expectations will follow suit over time.

With all due reservations about uncertainties in domestic politics and the global affairs, both of which could change the situation in coming months, we expect a steady stream of policy rate cuts through 2025 and into 2026.

We project a total reduction of 2 percentage points in 2025, bringing the policy rate to 6.5% by the year-end. In H1/2026, we anticipate rate cuts totalling another percentage point, leaving the policy rate at 5.5% in the middle of the year. Naturally, economic and inflation developments will determine whether average interest rates lie above or below that level over the medium term.

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