We expect the Central Bank (CBI) Monetary Policy Committee (MPC) to decide to hold the policy rate unchanged on 18 November, the final interest rate decision date of the year. According to our forecast, the CBI’s key interest rate will remain 1.0%, where it has been since this May. The economic outlook has fluctuated somewhat in the recent term, but in the main, it still appears that a tough winter is ahead, although the situation could improve over the course of next year. Inflation has risen but still seems to be anchored pretty firmly to the inflation target. And last but not least, there is every reason to consider using monetary policy instruments other than changes in the policy rate to cushion against the downturn. In this context, communicating a clearer sense of direction is vital under the current circumstances.

In October, the MPC voted unanimously to hold the policy rate unchanged. The forward guidance in the MPC’s October statement was a verbatim repetition of the guidance from August:

More firmly anchored inflation expectations provide monetary policy the scope to respond decisively to the deteriorating economic outlook. Lower interest rates, together with actions taken by the Bank this spring, have supported domestic demand. The impact of these measures has yet to emerge in full, however, and they will continue to support the economy and facilitate a more rapid recovery than would otherwise occur.

The MPC will continue to monitor economic developments and will use the tools at its disposal to support the domestic economy and ensure that the more accommodative monetary stance is transmitted normally to households and businesses.

In our opinion, this suggests that the MPC is satisfied with the situation for the present and will probably not change the CBI’s key interest in the near future unless the outlook changes markedly. In this context, Governor Ásgeir Jónsson said at the bank’s press conference that the impact of policy rate cuts and other measures was still coming to the fore. It was possible, even, that the full effect would not surface until the end of the pandemic approached, uncertainty subsided, and firms began to use low interest rates as a springboard for investment.

On the other hand, one could put an increasingly larger question mark by that last sentence. Despite the rise of the third wave of COVID-19 in October, domestic long-term interest rates have risen significantly in the recent past and have begun affecting households’ and businesses’ credit terms. Yet the CBI appears very reluctant to brandish the weapon it introduced this spring as a response to just this situation. The policy instrument in question, of course, is the bank’s planned purchase of Treasury bonds for up to ISK 150bn, only a tiny fraction of which it has exercised to date.

In our opinion, it would be best to ramp up the purchases strongly – and sooner, not later. Also needed is a much clearer explanation of the objective of the transactions and how the bond purchase programme might develop in response to shifts in long-term interest rates and the economic outlook. It is also vital that the MPC’s forward guidance provide a much clearer view than it has recently of when, and under what circumstances, the monetary stance will change again.

A hard winter could usher in a sunny summer economy

This autumn has certainly been eventful in terms of the economic outlook. Things started looking up during the summer, only for hopes to be dashed by the third wave of the COVID-19 pandemic and a resumption of travel restrictions. In the past few days, the outlook has brightened, however, with good news about the development of a vaccine. But even so, the overall economic outlook is broadly as it was this past summer. The tone of recent macroeconomic forecasts accords well with our own September forecast. Clearly, we are headed for a bleak winter, one in which economic policy must push back with all its might against the downward cycle in order to support households and businesses until prospects improve once again.

If efforts in this direction bear fruit, and if the pandemic is clearly on a downward trajectory before next year’s peak tourism season, we can expect a brisk economic recovery later in 2021. The crisis would therefore be brief, albeit deep. But the Government should be prepared for setbacks and must anticipate the possibility that the economic recovery will take longer to solidify. In this context, it is particularly important to mitigate, to the extent possible, any uncertainty about the planned responses to such setbacks, not least the monetary policy response.

According to the minutes from the MPC’s October meeting, the Committee was of the view that lower interest rates had supported domestic demand and that, in particular, the rate cuts had been transmitted effectively to households, as could be seen in robust housing market activity in recent months. This is all true. Private consumption has been much more buoyant in recent quarters than might have been expected earlier in the year, and the housing market has been stronger than we assumed in the fall. But this situation could disintegrate quite quickly if households’ financing terms take a turn for the worse.

What about quantitative easing?

As the chart indicates, the monetary stance in terms of developments in short-term real rates has eased considerably since the Covid Crisis struck. At the moment, real rates are negative by 1.5-2.9%. But this should come as no surprise in the midst of the deepest economic crisis Iceland has suffered in the history of the Republic, and it accords with both international trends and widely accepted views on sensible crisis-era economic policy.

On the other hand, long-term real rates have been developing in an unusual way recently. A clear example is the yield on RIKS30, currently the longest indexed Treasury bond series. After having bottomed out at -0.2% in the latter half of August, the yield has risen by nearly a percentage point, to 0.7% as of this writing. This is its highest since before the Covid Crisis struck. Similar patterns can be seen in long-term rates on nominal Treasury bonds, as well as other long-term bond market rates.

The trend of the past few weeks is unparalleled in other advanced economies, as governments the world over have prioritised the containment of long-term interest rates during the peak of the Covid Crisis. In Iceland, rising long-term rates are already starting to erode private sector credit terms, thereby working against the authorities’ stated objective of lightening the burden on households and businesses as much as possible until the economy begins to rebound.

Seen in this light, it is bewildering that despite having announced in the spring that it planned to buy up to ISK 150bn in Treasury bonds, the CBI has purchased only a minuscule amount to date. At the end of September, the CBI reported that its bond purchases up to that time had come to a scant ISK 900m. Based on developments since then, it would appear that whatever the bank did in October, it certainly did not have a decisive impact on the market. In addition to this, we have found the discussions at the MPC’s last interest rate decision meetings rather bizarre. On quantitative easing, the minutes state as follows:

Thus far, there had not been a need for large-scale bond purchases, as the supply of Treasury bonds had not yet increased significantly and both price formation and market functioning were normal. Members agreed that even though long-term bond market yields had eased upwards recently, decisive action was not warranted for the present.

The Committee appeared not to take account of the fact that large Treasury bond issues had been in the pipeline ever since the spring and that price formation in the market was probably affected by that expectation to an increasing degree, even though the supply had not yet “arrived”. On this topic, no less than on the policy rate, we consider forward guidance important, as the markets are indeed forward-looking.

We hope this situation will be remedied next week. First of all, we would find it useful if the CBI were to enter the bond market decisively on the buying side – sooner rather than later. There is much greater countercyclical value in containing long-term interest rates over the coming months and quarters than waiting until later on, when households and businesses can better afford higher long-term interest rates – irrespective of the Treasury’s financing needs. Second, there is a need for much clearer information about the purpose of the Treasury bond purchases and how they will be structured vis-à-vis conditions in the economy and the bond market. Presumably, such information would lend greater strength to the measures and ultimately reduce the amount of money required to keep long-term rates in check while low interest rates are of greatest benefit.

Inflation target still anchored despite inflation spike

Inflation has been on the rise this year. It measured 1.7% at the beginning of the year and, by October, had more than doubled, to 3.6%. Most of the inflation spike is due to the depreciation of the ISK, although domestic inflationary pressures have also been relatively strong. Furthermore, house prices have proven immune to the virus and have therefore provided less of a counterweight against other components of inflation than we had anticipated.

The outlook is for relatively high inflation in the near term. According to our most recent forecast, it will hover around 4% over the coming winter and will not align with the target again until the beginning of 2022.

Fortunately, inflation expectations appear thus far to be firmly anchored, as they have withstood the pressures of a deteriorating short-term outlook. The results of the CBI’s newly published market expectations survey suggest that market participants generally expect inflation to taper off rather quickly. According to the median response, inflation will be quite close to the CBI’s 2.5% target a year from now, and the general expectation is that it will remain at target, on average, in the next few years.

The breakeven inflation rate in the bond market tells a similar tale. Although it has risen since the spring, in recent weeks it has remained within striking distance of the CBI’s 2.5% target for all maturities, and if adjusted for the built-in uncertainty premium, the breakeven rate can be said to indicate that the inflation target enjoys significant credibility. Furthermore, in the autumn survey among executives from Iceland’s 400 largest companies, carried out by Gallup for the Confederation of Icelandic Employers and the CBI, respondents said they expected inflation to be close to the target over the next two years and at target in five years. This is a most welcome development, which makes monetary policy conduct that much easier for the CBI during the current crisis. It should also make it easier for the MPC to decide to take more assertive action to curb the rise in long-term interest rates and to provide clear messaging on an accommodative monetary stance while the crisis is ongoing.

Monetary policy to stay loose for a while

As should be clear from the discussion above, we consider it best, under current circumstances, that the CBI act to contain long-term interest rates and hone the messaging in its forward guidance rather than further lowering short-term interest rates, including the bank’s key rate. But the possibility of a further policy rate cut this winter cannot be ruled out, especially if the Corona Crisis has more unpleasant surprises in store later in the season.

Assuming that the pandemic has begun to taper off markedly before next year’s peak tourist season, as is assumed in our macroeconomic forecast from September, the CBI is likely to consider raising interest rates later in 2021. But it will probably move slowly in that direction, as we expect inflation to fall steadily over the same period, which will accordingly reduce the need for a tighter monetary stance.

The uncertainty in the long-term forecast is concentrated somewhat on the downside, however; i.e., policy rate hikes may be longer in coming than we have projected here. We also consider it relatively unlikely that rates will return in the foreseeable future to the level prevailing until mid-2019. This is due to a number of factors, including the prospect of weaker growth in GDP and investment, an increased propensity to save, and lower global interest rates.