We project that the Central Bank of Iceland (CBI) Monetary Policy Committee (MPC) will decide to hold the bank’s policy interest rate unchanged on 11 December, its next decision date. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 3.0%, down from 4.5% at the beginning of this year.

At its last meeting, in November, the MPC voted unanimously to lower the policy rate by 0.25 points. It was the third time in a row that all members agreed on a rate cut. The Committee did discuss the possibility of keeping rates unchanged in November, however.

As possible grounds for unchanged interest rates, they mentioned several arguments: underlying inflation had proven persistent, fiscal easing had diminished the need for monetary easing, interest rates were below the estimated neutral real rate, and there were signs that an economic turnaround may already have begun. Moreover, the slack in the economy was relatively small.

MPC members also discussed several arguments in favour of a rate cut: the GDP growth outlook had deteriorated, pessimism had intensified, the outlook was for inflation to decline swiftly, inflation expectations had fallen, and the CBI’s real rate had therefore risen slightly. Furthermore, it could be deemed appropriate to lower nominal interest rates further in order to reduce the risk of a further economic contraction in an environment of pronounced uncertainty.

The forward guidance from the MPC was neutral in November, although the Committee signalled reasonably clearly that, other things being equal, no further rate cuts were in the cards for the present:

The Bank’s interest rates have been cut by 1.5 percentage points since the spring, and the impact of this has yet to come fully to the fore. Lower interest rates have supported demand, and based on the Bank’s forecast, the current interest rate level should suffice to ensure medium-term price stability and full capacity utilisation.

Given these statements and the short time since the last interest rate decision, plus the fact that recent statistics have been well in line with the CBI’s November forecast, we think major changes would have to occur in order for the MPC to change its tack and lower rates further at next week’s meeting. If the MPC did so, it would simply look a little odd, and such a decision would do nothing to enhance transparency and predictability of monetary policy.

We therefore expect that the arguments for unchanged interest rates will outweigh the arguments for a rate cut.

GDP growth set to be flat in 2019

Although the economy appears to be weathering the initial impact of the Q1/2019 export shocks reasonably well, statistics indicate a distinct cooling. According to Statistics Iceland’s (SI) national accounts figures for the first three quarters of the year, GDP growth measured 0.2% for the nine-month period. Domestic demand contracted by 0.9% year-on-year during the period, however, owing largely to a 23% contraction in business investment. Exports contracted by nearly 7% during the three-quarter period, yet the contraction in imports was even sharper, at nearly 10%, which is the main reason why the overall national accounts outcome was positive.

In most respects, the CBI’s most recent macroeconomic forecast was similar to SI’s 9m/2019 figures. The CBI forecast, published in November, assumed a 0.9% contraction in domestic demand and a 0.2% contraction in GDP for the year as a whole. Thereafter, the CBI projects GDP growth at 1.6% in 2020 and 2.9% in 2021. However, the bank is slightly more optimistic than we are on this point. In September, ÍSB Research projected GDP growth at -0.1% in 2019, +1.3% in 2020, and +2.8% in 2021.

Other recent indicators confirm that the economy is quite resilient despite this year’s setbacks. For example, the current account surplus is still sizeable, unemployment has risen less than was widely feared earlier in the year, and private sector sentiment appears to have bottomed out and begun rising again.

Presumably, recent economic developments will not materially change MPC members’ opinion on the near-term economic outlook. On the other hand, the minutes from the MPC’s November meeting stated that members considered the uncertainty in the forecast to be concentrated on the downside. As regards the near-term outlook, this is certainly a justifiable view.

Inflation expectations at target

Inflation has declined markedly since the beginning of the year, measuring 2.7% in November, after peaking at 3.7% at the end of 2018. It is now at its lowest in more than a year. We expect it to keep falling, dip below the CBI’s 2.5% target in the next few months, and hover around the target thereafter. In November, the CBI forecast that inflation would average 2.5% in Q4 and then remain close to the target until end-2022. This inflation forecast from the CBI is considerably more optimistic than its immediate predecessor. Our year-2020 inflation forecast is similar to the CBI’s; however, we expect inflation to inch upwards over time, although we, too, expect it to remain within striking distance of the target.

The breakeven inflation rate in the bond market has fallen markedly in 2019 to date, as have survey-based inflation expectations. At the beginning of the year, the breakeven rate (both short-term and long-term) was over 4%. In recent weeks, the medium-term breakeven rate has been close to the 2.5% target, and the ten-year breakeven rate has been around 3.0%. However, the latter can also be said to reflect target-level expectations, as the long-term breakeven rate usually includes an uncertainty premium. The ten-year rate has actually risen marginally in recent weeks, but if that trend does not continue, this increase alone should not upend the MPC’s assessment.

Scope exists for a low real policy rate

The CBI has lowered the policy rate by 1.5 percentage points since the beginning of the year; however, the real policy rate, which reflects the monetary stance, has fallen much less, owing to declining inflation and inflation expectations. According to various measures, the real policy rate ranged between 0.2% and 0.8% in November, whereas in April (before the monetary easing phase began) it lay in the 0.5-1.3% range.

In November, the MPC was of the view that the rate cuts since spring had been transmitted quite effectively to private sector interest rates. After the November rate cut, MPC members were of the opinion that the policy rate level should suffice to ensure medium-term price stability and full capacity utilisation. In this context, the MPC appeared to take into consideration the CBI’s new assessment of the neutral real rate, about 2%.

Long-term real rates in the market rose somewhat following the November rate cut, after having fallen markedly before then. The Committee’s assessment that the interest rate cuts in 2019 to date had been sufficient appears to have been somewhat at odds with market opinion. Long-term real rates in the market are now around 0.8-0.9%, about the same as at mid-year. In other words, some portion of the transmission of the CBI rate cut has reversed since the November decision, and this could affect some Committee members’ opinion on whether the monetary easing to date has been sufficient.

Also worth noting is the fact that financial institutions have begun showing signs of reduced appetite for lending; furthermore, several of them have tightened their lending requirements. If this continues, the MPC (and other authorities) will have to consider whether a policy response is warranted, as is discussed below.

Interest rate differential with abroad widens again

After narrowing significantly in the first ten months of 2019, the interest rate differential with abroad has widened again. The spread between 10-year Icelandic Treasury bonds and comparable bonds in euros is currently just over 4.0%, as opposed to just over 3.0% for bonds in pounds sterling and about 2.0% for US dollar bonds. These spreads are similar to those in early September. However, the same spreads ranged from 5.2% (EUR) to 2.8% (USD) at the beginning of the year. The recent increase is therefore small in comparison with the narrowing early this year, and it is due entirely to a rise in long-term rates in Iceland over the past few weeks, as interest rates abroad have also inched upwards over the same period.

The MPC has often taken note of the interest rate differential. The change in the past few weeks will probably have little impact on the Committee’s assessment this time, yet if the interest rate spread continues to widen, it could provide grounds for a policy rate cut.

Has the policy rate bottomed out?

Even though we forecast that the policy rate will be held unchanged in the near future, we think it likelier than not that the MPC will cut rates at some point in coming quarters, so as to lower the real rate again. Whether a nominal rate cut materialises or not, and how large it might be, will depend on how economic developments compare with recent macroeconomic forecasts.

In our opinion, however, further policy rate cuts will do limited good by themselves; they must be accompanied by easing of macroprudential tools and other financial system policy instruments that make it difficult for firms (smaller ones in particular) and households to obtain credit financing on acceptable terms. Among these tools are stiff capital and liquidity ratio requirements, a heavy tax burden, and a cumbersome internal and external regulatory framework that, as many have pointed out, increases costs considerably.

The outlook for 2021 is for interest rates to ease upwards again as the economy starts to pick up and inflationary pressures gain a little steam. The possibility of further monetary easing cannot be ruled out, however, if the economic downturn proves deeper and/or more protracted than we have assumed, which would tend to weaken inflationary pressures and widen the slack in output over the course of 2020.