Today’s decision is at odds with all published forecasts, which provided unanimously for an unchanged policy rate. We had projected that the MPC would hold interest rates steady but signal that the monetary easing phase was in the starting blocks. When we prepared that forecast, we took particular note of the MPC’s stern messaging from August, when the possibility of a rate cut was not even mentioned. But in our assessment, today’s decision is well supported, and the time is right to start unwinding the monetary stance.

Nevertheless, market opinion has been divided on whether rates would be lowered or held unchanged, and in the past few days, yield curves in the bond market have reflected a significant likelihood of a rate cut.

The tone in today’s MPC statement is rather cautious overall, indicating that monetary easing will proceed at a slow pace initially and the real rate will be held relatively high.

The highlights from the MPC statement are as follows:

Inflation has eased recently, measuring 5.4% in September.

• Although certain one-off items weigh heavily, the scope and frequency of price increases have tapered off.
• Underlying inflation has subsided as well, and the breakeven inflation rate in the bond market has fallen.
• Economic activity has continued to ease in tandem with the tighter monetary stance.
• Furthermore, there are signs that labour market pressures have subsided, and households and businesses have grown more pessimistic.
• Persistent inflation, inflation expectations above target, and strong domestic demand call for caution, however.
• As a result, it is necessary to maintain an appropriately tight monetary stance in order to bring inflation back to target within an acceptable time frame.

The forward guidance in this morning’s MPC statement is quite different from that in August. It is short and sweet, reading as follows:

As before, near-term monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

For the sake of comparison, the forward guidance in the August statement read as follows:

The MPC is of the view that the current monetary stance is sufficient to bring inflation back to target, but persistent inflation and strong domestic demand call for caution. As before, monetary policy formulation will be determined by developments in economic activity, inflation, and inflation expectations.

Divided opinion within the MPC?

At the CBI’s press conference on today’s interest rate decision, it emerged that even though one-off items carried a fair amount of weight in the drop in inflation, price hikes had eased overall in terms of scope and frequency. Governor Ásgeir Jónsson pointed out that a number of metrics other than inflation indicated that pressures were easing. Labour demand was on the decline, for instance, except in the construction industry.

When asked about an appropriate policy stance, CBI officials said the MPC was satisfied with the current one and believed that the monetary stance was sufficient to bring inflation back to target within an acceptable time frame. With a 25-bp rate cut, the Committee was embarking on a cautious unwinding phase, which would be put on hold if inflation stopped falling and/or the economy stopped cooling. Although waiting for more unambiguous signs of disinflation and cooling would have been an option, the MPC had considered it preferable to start with an incremental rate cut. We certainly agree with this.

It seemed that there was divided opinion among CBI officials concerning how much change had taken place between meetings. Rannveig Sigurðardóttir, Deputy Governor for Monetary Policy, answered questions on this point by saying that there had not necessarily been substantial change since the August decision, when the MPC had adopted a distinctly stern tone. Ásgeir disagreed, saying he thought there had been marked change in the interim. It then emerged in remarks from both of them that MPC members had had differing views on the various determinants and had assigned different weights to them during the interest rate decision process.

We interpret this to mean that the Committee did not reach a unanimous conclusion this time. We would not be surprised to discover that some of its members had voted against a rate cut at this juncture, but we will find out when the MPC minutes are published two weeks from now.

Where is the policy rate heading?

In a nutshell, this is how we see today’s news and the current outlook: The monetary easing phase has begun, but the MPC will want to control the pace in the coming term so as to prevent a steep drop in the real rate. The outlook is thus for another rate cut in November, but we think the size of the reduction – whether it will be another 25bp, or more – will be determined by developments in inflation and economic activity.

If inflation and economic activity develop in line with our newly published macroeconomic forecast, the pace of rate cuts will most likely increase as 2025 progresses. The policy rate could therefore be down to 7.5% by year-end 2025 and 5.5% by H2/2026.