According to the minutes from the MPC’s August meeting, the following points were uppermost in Committee members’ minds at that time:

• Inflation was persistent, and inflation expectations were broadly unchanged.
• The MPC was of the view that domestic demand was still relatively strong and there were few indications that the economy had cooled since the previous meeting, whether in terms of the labour market or the housing market.
• Wage increases in previous months and fiscal measures relating to wage agreements appeared to have supported demand.
• The household saving rate was still relatively high, and it was positive to see how effectively that channel of monetary policy had functioned in the recent term, although a high saving rate could conceivably fuel demand further ahead.
• The Government’s buy-up of homes in Grindavík had stimulated the real estate market, although the MPC considered those effects temporary.
• Even if the effects of Grindavík residents’ housing market activity were ignored, the market appeared relatively strong.
• In view of robust economic activity and how persistent inflation had been, it could prove necessary to maintain a tight monetary stance for longer than would otherwise be necessary.
• It could be difficult to bring inflation back to target within an acceptable time frame unless the economy cooled significantly.
• The MPC was of the opinion that because indications that inflationary pressures and inflation expectations were subsiding to a sufficient degree had not come clearly enough to the fore, the monetary stance should remain tight.
• Although the CBI’s interest rate hikes had been effective in narrowing the output gap and fostering disinflation, progress had been slower than expected.

The economy is cooling

Our recent macroeconomic forecast explores recent economic developments and prospects for the coming term.

GDP contracted nearly 2% year-on-year in H1/2024. The failed capelin catch was a major factor, but there were headwinds in other exports, and private consumption shrank.

The outlook is for GDP growth to measure 0.3% in 2024 as a whole This is the weakest GDP growth rate since the financial crisis of 2009-2010, apart from the pandemic year 2020. The year 2024 actually marks a turning point, even though a full-year contraction is not likely. This is also a far weaker growth rate than we forecast in May. The deviation stems from a poorer outlook for exports, stronger imports, and the effects of high interest rates on demand in H2.

For 2025, we forecast GDP growth at 1.2%. Private consumption and exports will gain steam, but investment looks set to be all but unchanged YoY. For 2026, the outlook is for 2.5% GDP growth, with investment set to rebound and private consumption and exports to pick up further.

We now project somewhat slower growth over the forecast horizon than we did in May, owing to slower growth in tourism, relatively weak growth in marine product exports, and the long-term impact of a high real interest rate. On the other hand, growth in recent years now measures higher than previous figures had indicated. Therefore, slower growth in this forecast does not necessarily mean more slack later on. Nevertheless, such a revision affects measured developments in GDP per hour worked, and it should not be interpreted merely as a sign that excess growth – i.e., growth in GDP over and above capacity – is correspondingly greater.

It should be noted that in its August forecast, the CBI projected Q2 GDP growth at 2%, whereas the actual outcome according to preliminary figures from SI was a contraction of 0.3%. In all, the CBI forecast GDP growth at 0.5% in 2024 and 2.0% in 2025. Our forecast therefore assumes that growth will be  1 percentage point weaker in 2024 and 2025 combined than the CBI’s does.

The bank’s officials have pointed out that SI’s first national accounts figures are often revised upwards later on and should therefore be interpreted with caution. On the other hand, it has sometimes seemed to us that when SI’s figures are revised upwards, as they were at the time of the most recent publication of national accounts, these same officials have interpreted this as additional grounds for a tighter policy stance. To us, this looks like a tendency to double-count, which needlessly complicates the MPC’s message about its assessment of economic situation.

Inflation eases and the breakeven rate falls

Although the Monetary Policy Committee (MPC) took a fairly stern tone at the time of its August interest rate decision, a number of factors have supported monetary policy since. Inflation has subsided, and the near-term outlook has improved somewhat.

Inflation measured 6.0% in August, a decline of 0.3 percentage points from the July figure the MPC had in hand at its last rate-setting meeting. Various measures of underlying inflation declined in August as well.

We assume that disinflation will continue for the remainder of the year, and we project that inflation will measure 5.1% at the year-end. In 2025, the outlook is for inflation to fall further, perhaps to around 3% by the end of that year.

The breakeven inflation rate has fallen markedly since the August decision date, although long-term inflation expectations remain high by most measures.

The change has been most pronounced in the short-term breakeven rate. For instance, the two-year breakeven rate is now 3.8%, down from 4.7% at the time of the last interest rate decision. Over the same period, the five-year breakeven inflation rate has fallen from 4.0% to 3.7%, and the ten-year rate has tapered off from 3.9% to 3.7%. Presumably, part of this shift stems from expectations that the change in taxation of motor vehicles, set to take effect at year-end 2024, will lead to a sudden plunge in the CPI. But it is not entirely clear that this will indeed happen, and actual developments will depend on how the tax change is orchestrated.

Despite the developments described above, long-term inflation expectations have changed little as yet – at least in terms of households’, businesses’, and market participants’ responses to expectations surveys. Understandably, MPC members are very concerned about persistently high inflation expectations, which make it more difficult to attain the inflation target.

Nonetheless, we have pointed out before that it can be dubious to focus solely on long-term expectations and require unequivocally that they decline before interest rates can be lowered, if other related indicators are moving in the right direction at the same time. If inflation expectations have become unmoored from the target, a sizeable decline in inflation could be needed to bring expectations down again. In other words, a situation featuring adaptive inflation expectations can develop, where inflation leads expectations and not the reverse. When this happens, inflation must fall without support from stable long-term inflation expectations, as has been the case in Iceland in recent quarters.

A growing interest rate differential with abroad is an important factor

Iceland’s interest rate differential vis-à-vis its main trading partners is quite wide at present, particularly for short-term rates. Policy interest rates in the other Nordic countries range between 3.25% and 4.5%. In the eurozone, the policy rate is 3.65%, in the UK it is 5.0%, and in the US it is 4.75-5.0%.

Of no less importance for the impact of monetary policy in Iceland is the fact that many countries have already begun easing their monetary policy stance. The US Federal Reserve Bank recently cut its key interest rate by 0.5 percentage points, and the central banks in Europe, the UK, and the Nordic region (except Norway) had already lowered theirs. Furthermore, it is forecast that in all of these economies, monetary easing will continue well into 2025, as the chart indicates.

The interest rate differential could prove to have a strong effect, not least if it widens in the coming term. In the past few months, foreign investors have demonstrated little appetite for Icelandic interest rates, after a surge in bond purchases early this year. That could change again in coming quarters, however. Although moderate inflows for carry trade are positive (as long as they are not funding a growing current account deficit), moderation is indeed best in most matters, not least this one. A wide interest rate spread could push the ISK exchange rate too far upwards, erode Iceland’s competitive position, exacerbate cyclicality, and lead to a more abrupt exchange rate adjustment later on. The outlook for the exchange rate differential is therefore a factor that the MPC must certainly consider in upcoming interest rate decisions.

Rate cut before the year-end?

Our recently published macroeconomic forecast included a discussion of the outlook for short- and long-term interest rates in the near future.

After a steep monetary tightening phase starting in spring 2021, the CBI’s policy rate has been unchanged at 9.25% since August 2023. The real policy rate has surged recently, though, reflecting the currently tight monetary stance.

Expectations of a rate cut in Q3 went up in smoke, however, after a summer of stubborn inflation and stronger-than-expected economic activity.

If our economic and inflation forecasts materialise, the monetary easing phase could start on 20 November, the last rate-setting date of the year. But the margin for error is slim, and unless everything more or less lines up, the easing phase will be delayed until next year.

Although the Governor of the CBI signalled that interest rates could fall rather swiftly once easing starts, we think it likelier – and wiser – for the MPC to exercise caution at the outset. A robust investment level and underlying pressures in the housing market, plus the persistent inflation we have seen recently, are all valid reasons to avoid unwinding the monetary stance too quickly. Conversely, there is a greater risk that monetary policy will prove procyclical if the MPC chooses to wait until inflation is indisputably moving back to target and then start lowering the policy rate in large steps.

We project that the policy rate will fall to 8.25% by mid-2025, 7.5% at the end of 2025, and 5.5% towards the end of the forecast horizon. We think this last figure is close to the current equilibrium rate. That forecast must nevertheless be considered in light of our projection of a relatively favourable economic outlook for the coming term. If the economy suffers a major setback this coming winter, monetary policy should respond by unwinding interest rates more rapidly than is forecast here.

Long-term interest rates are high at present. Based on Treasury yield curves, nominal ten-year base rates are now around 6.8%, and the corresponding real rate on indexed bonds is close to 2.7%. We estimate that long-term nominal rates could fall to 5.8% and real rates to 2.2% over the forecast horizon. Accordingly, the long-term breakeven inflation rate would be 3.6%, as compared with the current 4.0%. It should be borne in mind, however, that long-term inflation expectations are probably lower than this, as the breakeven rate includes an uncertainty premium.