Today’s MPC Statement was short and sweet. It began by noting that GDP growth had turned out weaker in H1/2021 than had been assumed in the CBI’s August forecast, and then went on to say that domestic demand had grown as expected. There are signs of a strong economic recovery in Q3, however, and the Committee is of the view that the outlook for 2021 as a whole is still in line with the August forecast, which assumed that GDP growth would measure 4% for the year.

The MPC appears a bit ambivalent about how to interpret current indicators of the inflation outlook and inflation expectations. Today’s statement makes reference to recently released September inflation data, which show that the contribution of the housing component has increased steadily and that housing now explains a fair share of last month’s 4.4% headline inflation figure. Yet underlying inflation continued to ease.

The MPC statement also points out that global supply-chain disruptions could prove more persistent than previously hoped, and their impact on production and distribution costs more long-lasting.

What is of greater concern to the MPC, though, is the fact that while underlying inflation is subsiding, inflation expectations appear to have started rising again. But the Committee stressed that it is too soon to say whether inflation expectations are becoming less firmly anchored to the inflation target. The MPC statement did not specify which expectations it was referring to, but presumably it meant the breakeven inflation rate in the bond market, which has indeed risen in recent weeks. On the other hand, a recent measurement of corporate expectations was marginally more upbeat about near-term inflation than its predecessor, as we have discussed recently.

The forward guidance in the MPC statement was cogent and concise – indeed, it is repeated verbatim from the last interest rate decision:

“The MPC will apply the tools at its disposal to ensure that inflation eases back to the target within an acceptable time frame.”

We interpret this to mean that, all else being equal, the CBI is on a steady monetary tightening trajectory, as was already clear from the statements made by bank officials at the August press conference, as well as the minutes of the August meeting.

Discussions of domestic and imported inflationary pressures

At today’s press conference on the interest rate decision, it came to light that the MPC ignores, at least in part, the temporary inflationary pressures caused by supply-chain disruptions abroad. That said, it matters in this context how firmly inflation expectations are anchored. If the anchor has begun to weaken, it will be necessary to respond to inflationary pressures, no matter what their source. On this score, CBI officials are presumably thinking that although monetary policy can do precious little about foreign prices, higher domestic interest rates can affect the ISK exchange rate, and they can certainly put a damper on domestic cost pressures over time. But the bank’s officials are of the view that developments abroad have only a modest impact on domestic inflation, at least thus far.

In Governor Ásgeir Jónsson’s responses to questions posed at the press conference, one thing that emerged was his opinion that the CBI had been successful in containing inflation recently. Inflation excluding housing was close to target, and house prices were the main driver of excess inflation at present. By law, the CBI is required to base its decisions on CPI inflation, which is greatly affected by house prices through the imputed rent component. Furthermore, developments in house prices pass through quickly to measured inflation.

ÝA number of indicators show the tension in the housing market, including a short average time-to-sale and a large share of properties sold at a premium on the asking price. This situation, which reflects a mismatch between supply and demand, is probably temporary, at least in part, according to Ásgeir. As a result, the bulk of the inflationary pressures could subside relatively quickly. Furthermore, the Financial Stability Committee’s policy instruments should keep the situation grounded and help to calm the market further ahead. The policy instruments in question are the cap on loan-to-value (LTV) ratios, lowered this past summer from 85% to 80% for most buyers, and the newly introduced maximum debt service-to-income (DSTI) ratio, set at 35% for all but first-time buyers.

The shortage of supply is also likely to correct itself over time. At the moment, contractors are prioritising completion of new residential properties and putting them on the market as soon as possible. There is still space for new residential constructions in most areas, and strong demand will eventually give rise to an increase in supply.

In response to questions on recent indicators of a brighter economic outlook for this winter – such as the generous capelin quota guidance and the expected opening of the US to European tourists – Ásgeir stressed that it was wise to interpret such news with caution. But we think it likely that these factors will affect the CBI’s next macroeconomic forecast, to be published concurrent with the final interest rate decision of the year, scheduled for mid-November.

Another rate hike in November?

The tone taken in today’s interest rate decision is largely as we had expected. In our recent policy rate forecast, we assumed that the CBI would hold rates unchanged in November. But the possibility of a rate hike has grown stronger, and if the inflation outlook does not improve and the prospects for the economic recovery don’t grow dimmer in the interim, the MPC way well bump the policy rate upwards once again.