The highlights from today’s the MPC statement are as follows:

• Inflation has risen marginally since the MPC’s last meeting, after having eased earlier this year.
• Underlying inflation remains high and price increases are widespread, even though the contribution from the housing component is still significant.
• Inflation expectations are broadly unchanged and have remained above target.
• Domestic demand has eased in the past year, in line with a tighter monetary stance.
• Some demand pressures remain in the domestic economy, however, and they have subsided very little since the MPC’s May meeting.
• It therefore appears that it will take some time to achieve an acceptable rate of disinflation.

This last sentence is striking, and an indication that the MPC is looking beyond the next few months as it considers unwinding the policy rate.

The CBI sees weaker GDP growth on the horizon

The CBI’s new macroeconomic forecast, published today in Monetary Bulletin, provides for considerably more sluggish output growth than was assumed in its May forecast. The bank now projects growth at 0.5% this year, 2.0% in 2025, and 2.6% in 2026, as compared with 1.1%, 2.3%, and 2.9%, respectively, in the May forecast. A poorer outlook for growth in tourism is a strong factor in this downward revision. Furthermore, the CBI expects weaker growth in business investment this year, although it has revised its year-2024 residential investment forecast upwards.

At this morning’s press conference, the Governor said he considered the discourse about the dampening impact of high interest rates on the construction sector to be somewhat inaccurate. He went on to say that anyone who could find the business end of a hammer [ATH: If you think this sounds too snarky, we can be more literal and say “anyone who could wield a hammer”] had already gotten a job in the industry, most construction companies were looking to take on workers, and lending to the sector was strong. All of this indicated that the construction industry was firing on all cylinders, and there were no signs that interest rates were cutting into the supply of new housing.

Inflation outlook broadly unchanged since the spring

The CBI has revised its near-term inflation forecast upwards since May, while noting that the revision stems from a poorer initial position and the inflation outlook is actually more or less unchanged. The bank forecasts that inflation will average just over 6% in H2/2024, followed by 4.2% in 2025 and 2.9% in 2026. According to the new forecast, inflation will realign with the 2.5% inflation target two years from now.

There has been plenty of speculation in recent weeks about how the forthcoming change in taxation of fossil fuel-powered motor vehicles – i.e., the replacement of fuel taxes with a per-kilometre charge – will affect CPI measurements at the turn of the year. If the new fee structure is incorporated into the index in a manner similar to that used for the Hvalfjörður and Vaðlaheiðargöng tunnels, the impact on the CPI will be negligible. On the other hand, Statistics Iceland (SI) could opt to structure the change in the way it did when it replaced National Broadcasting Service user fees with a head tax. If it chooses this option, headline inflation could be reduced by around 1 percentage point in 2025, although the effects will disappear at the beginning of 2026.

According to the discussion in Monetary Bulletin, the CBI considers the former option more likely, with the aforementioned negligible impact on measured inflation in 2025.

Policy rate cut in 2024 less likely

The forward guidance in today’s MPC statement has changed since May. It reads as follows (changes from the May statement in boldface):

The MPC is of the view that the current monetary stance is sufficient to bring inflation back to target, but persistent inflation and strong domestic demand call for caution. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

For the sake of comparison, the forward guidance in the May statement read as follows:

The MPC is of the view that there is an increased probability that the current monetary stance is sufficient to bring inflation back to target within an acceptable time frame. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

To put it succinctly, we interpret the forward guidance as follows: The MPC thinks it will probably not need to raise the policy rate further but expects a delay before the monetary easing phase can begin.

This also aligns with the Governor’s statement at this morning’s press conference, to the effect that the current real policy rate – around 4% in terms of the average of forward-looking measures – was probably appropriate. However, CBI officials also noted at today’s press conference that in the past three months, inflation and the economy more broadly have developed quite a bit differently than was expected in the spring: inflation has been higher and the economy has cooled more slowly. For instance, the initial impact of wage agreements has been stronger on the demand side, although the contracts have been a positive step overall. Furthermore, the peak tourist season is turning out more favourably than previously anticipated, as we have discussed in the recent term. As the Governor put it, we have lost three-and-a-half months of economic cooling and disinflation this summer.

As a result, we think it more likely than before that the monetary easing phase will not start until next year. A policy rate cut in October is probably off the table by now, but it is not inconceivable that the unwinding phase could begin in November – if inflation and inflation expectations develop favourably and clearer signs of a cooling economy emerge at the same time.