In February, the MPC voted unanimously to hold the policy rate unchanged. MPC members were of the view that lower interest rates had supported domestic demand and stimulated the housing market, although inflation above the upper deviation threshold of the target and higher underlying inflation gave cause for some concern. Members also agreed to maintain the current stance regarding other monetary policy instruments.

The forward guidance from the MPC was neutral this time:

The MPC will apply the tools at its disposal to support the domestic economy and ensure that inflation eases back to the target within an acceptable time frame.

Since the February meeting, the short-term inflation outlook has darkened slightly, and the global economic outlook has somewhat brightened. The path taken by the pandemic and the development and roll-out of vaccines has been a rocky one, but as before, it appears that a majority of the population in Iceland and its main trading partner countries will be inoculated before the autumn. Developments and prospects for the Icelandic economy are broadly as in February, and the medium-term inflation outlook is similarly unchanged. As a result, we think it likely that the MPC will hold a steady course in March, delivering unchanged interest rates and neutral forward guidance.

The worst of the Corona Crisis is probably over

Economic developments in recent quarters have turned out more favourable than was feared just alter the Corona Crisis struck. Preliminary figures from Statistics Iceland (SI) for 2020 indicate a 6.6% year-on-year contraction in GDP, whereas the CBI had forecast a contraction of 7.7% in its February Monetary Bulletin and we had projected a contraction of 8.7%. The difference between forecasts and actual figures lies primarily in stronger-than-expected domestic demand, while the contraction in exports was consistent with expectations.

Recent economic indicators suggest that domestic demand continues to be strong. Households’ payment card turnover in Iceland rose in real terms by almost 5% YoY in the first two months of 2021, although turnover abroad contracted by nearly half. This is consistent with the trend suggested by card turnover figures from previous months. Furthermore, the results of a newly published survey of corporate executives, carried out by the Confederation of Icelandic Employers and the Central Bank, indicates that expectations six months ahead have improved markedly in the recent term, as regards both domestic demand and the economy more generally.

There is still significant uncertainty about coming quarters, of course, centring mainly on how global efforts to quell the pandemic will fare. We think the outlook is still broadly in line with our January forecast, however: that tourism will start to rebound in H2 and the economy as a whole will rally simultaneously, with declining unemployment, rising foreign exchange revenues, a surge in upbeat consumer sentiment, and increased domestic economic activity. As a result, we believe our forecast and the CBI’s still rest on solid ground in this respect.

Inflation more persistent than expected

Inflation has developed less favourably than expected in recent months, for two main reasons: First of all, fuel prices have soared since the end of October, affecting domestic petrol prices and eventually pushing import prices upwards. Furthermore, house price inflation has been stronger than could have been expected at the time the pandemic struck, particularly because the more accommodative monetary stance has been transmitted effectively to lending rates.

Inflation currently measures 4.1%. It peaked in January at 4.3%, the largest deviation from the CBI’s inflation target since autumn 2013. According to the CBI’s last Monetary Bulletin, issued concurrent with the February interest rate decision, inflation was forecast to measure 3.9% in Q1 and then taper off quickly, reaching the CBI’s 2.5% inflation target by the year-end. Based on our most recent forecast, inflation looks set to measure 4.2% in Q1. Even so, we still expect a swift disinflation episode, with headline inflation aligning with the target by the end of the year. Thereafter, we expect inflation to remain just below the target until 2023.

Fortunately, there seems to be a widely held consensus that the current inflation spike is merely temporary and that the CBI will be successful in keeping inflation close to the target in the next few years. Recent surveys of corporate executives’ and market agents’ expectations show, for instance, that respondents expect inflation to be at the target a year from now and then remain there, on average, for another five years. Households are noticeably more pessimistic about the short-term inflation outlook but also think headline inflation will not stray too far from the target in the medium term. Households expect inflation to measure 4% in one year and then average 3% over the next five years.

Similar inferences can be made from the breakeven inflation rate in the bond market. The breakeven rate has risen somewhat since mid-2020 and is now 2.6% (three years), 2.8% (five years), and 3.0% (seven years). Given that the breakeven rate includes a premium for uncertainty about real returns on nominal bonds and is therefore not purely a reflection of inflation expectations, it is actually quite consistent with the CBI’s inflation target, although the upward trend in in recent months does give some cause for concern.

In February, the MPC expressed concerns about the previous few months’ rise in inflation and was of the view that stronger domestic demand could increase inflation persistence. MPC members also noted that the uneven impact of the Corona Crisis across various segments of the economy could weaken the disinflationary effect of the slack in output. It can be said that this is materialising to some extent, although we think it unnecessary to be overly worried, as the inflation outlook remains good and monetary policy enjoys considerable credibility. There is little doubt, though, that these concerns will make MPC members less likely to ease the monetary stance further in the coming term.

Steep real interest rate curve

In recent months, mounting inflation and a rising breakeven rate have lowered the real policy rate as measured by the criteria above. By other measures, the real policy rate has changed much less since November, when the last nominal rate cut was decided. By all metrics, however, the real policy rate is well below zero. Our estimates put it between -1.7% and -3.2% at present. The accommodative monetary stance can therefore be seen plainly in the short-term real rate, as short-term market rates have tracked the policy rate quite closely. Households and businesses have benefited from this trend, which has delivered more favourable lending rates and has provided a cushion against the blow dealt by the pandemic. Clear signs of this can be seen in the housing market, for instance, where turnover has been brisk and prices steadily rising despite the turmoil in the economy.

Long-term real rates tell a different story, however. They hit bottom in mid-2020 and then rose firmly last autumn but have been relatively stable since December. For example, the yield on RIKS30, the longest indexed Treasury series, was -0.2% in August 2020 but is now 0.6%, where it has hovered for the last four months or so. This rise in long-term real rates has pushed interest rates upwards on loans with longer fixed-rate periods, although the increase is not yet a large one and the real estate market remains lively.

Quantitative easing still limited

Nearly a year has passed since the CBI announced its intention to begin buying Treasury bonds so as to “ensure that the more accommodative monetary stance is transmitted normally to households and businesses across the yield curve.” The purchases have been much more modest than was widely expected, however. They total just under ISK 12bn, according to CBI data, whereas the bank’s announcement specified that they could range up to ISK 150bn. As the chart shows, the vast majority of the bond purchases to date have taken place in three periods: from early November until mid-December 2020, in the latter half of January 2021, and in March 2021. With these purchases, the CBI has slowed the rise in the nominal yield curve during the periods concerned. In a broader context, however, these actions pale into insignificance against the aggressive bond purchases undertaken by other central banks, as the amounts involved are of an entirely different magnitude and the impact on money holdings and interest rates is minor.

We have stressed repeatedly that we think it would be beneficial if these bond purchases were larger in scale while the outlook remains ambiguous and long-term interest rates relatively high. We are still of this opinion. The CBI’s focus in terms of increased money holdings and support for Treasury financing has shifted to foreign currency trades; i.e., the bank has supplied the Government with krónur in exchange for foreign currency the latter owned previously and supplemented with bond issues early this year. This is certainly a positive move, as it eases the Treasury’s domestic financing need and constitutes the equivalent of money printing, but the one need not rule out the other, in our opinion.

Interest rate hike unlikely in 2021

As before, we think the CBI will keep the policy rate unchanged at 0.75% for a while to come, until clearer signs of an economic recovery come to the fore. This will hardly occur before early next year. At the same time, inflation will subside quickly, according to our newly published inflation forecast, and the CBI will have less need to consider the potential medium-term impact of above-target inflation on the credibility of monetary policy. If this year’s economic recovery stalls, rate hikes will doubtless be even longer in coming, and if things turn truly sour, a rate cut sometime this year is not an impossibility. On the other hand, we consider it unlikely that rates will be raised until a year from now, even if the recovery comes sooner or advances more rapidly than we expect, as such a scenario would probably strengthen the ISK and push inflation downwards even faster.

From 2022 onwards, we expect the policy rate to rise slowly, to 3% by the end of the forecast horizon. Therefore, according to our forecast, the policy rate will not overtake inflation until the beginning of 2023. In our view, the uncertainty about this longer upward policy rate trajectory is concentrated on the downside because, as is discussed above, a speedier economic recovery will probably go hand-in-hand with a more rapid ISK appreciation and lower inflation.