The MPC is marginally more optimistic about the short-term inflation outlook, as headline inflation has fallen from 3.7% to 3.0% recently and the ISK has appreciated. The Committee mentions in particular that imported inflationary pressures have receded since the autumn and the impact of house prices on inflation has tapered off as well.

The MPC also mentions, correctly, that the breakeven inflation rate in the bond market has declined. The long-term breakeven rate was just over 4.0% at the time of the February policy rate decision but is now around 3.6%. This decline is due to a drop in nominal Treasury bond yields following the removal of the special reserve requirement on non-residents’ bond investments. In our opinion, the breakeven rate now reflects market agents’ inflation expectations, plus a premium for uncertainty, much more accurately than before. Assuming that the uncertainty premium is at least 0.5% — a cautious estimate, in our view — it therefore appears that inflation expectations in the market are not wildly out of line with the inflation target.

The MPC is concerned about the rise in households’ and businesses’ long-term inflation expectations, however. It estimates that because of this rise, the monetary stance is broadly unchanged in spite of the drop in both measured inflation and the breakeven inflation rate. In our opinion, the overall inflation outlook has improved somewhat, and the MPC, in assessing the monetary stance, could have assigned more weight to developments in inflation and the breakeven rate than to households’ and businesses’ expectations.

At the CBI press conference this morning, it emerged that new investments, on the one hand, and outflows stemming from the removal of controls on offshore krónur, on the other, have more or less offset one another. The stock of offshore krónur in the CBI’s accounts has shrunk by about ISK 10bn since the controls were lifted at the beginning of this month. It is unlikely, though, that this entire amount has been exported via the foreign exchange market. In particular, the large position that was discussed in connection with the maturity of the RIKB19 Treasury bond, and about which the CBI expressed concerns in its statement to Parliament, has not exited through the FX market to any significant degree, according to the Governor. Inflows into the stock market and Treasury bonds have played a role in the recent appreciation of the ISK, and outflows stemming from pension funds’ investments have eased in the recent past.

Wage agreements a key factor in policy rate developments

The forward guidance in today’s MPC statement is repeated verbatim from the Committee’s last statement:

The near-term monetary stance will depend on the interaction between a narrower output gap, wage-setting decisions, and developments in inflation and inflation expectations.

The MPC reiterates that it has both the will and the tools necessary to keep inflation and inflation expectations at target over the long term. This could call for a tighter monetary stance in coming months. Other decisions, particularly those relating to the labour market and fiscal policy, will be important in determining whether that will be the case and will affect the sacrifice cost in terms of lower employment.

It seems clear that the outcome of the ongoing wage negotiations will be a major factor in whether the policy rate is increased before mid-year. In our most recent inflation forecast, we estimate that the wage index will rise by 6.5% in 2019. This is similar to the forecast published by the CBI February. If wage increases this spring turn out substantially larger than this, we expect the CBI to respond with a rate hike in May or June. That said, our opinion is unchanged, in that we consider an unchanged policy rate the most likely outcome, although we do not exclude the possibility of a rate cut in H2 — provided that wage agreements provide for relatively modest pay rises.