In August, MPC members did agree that the impact of policy rate hikes was coming more strongly to the fore, as developments in both private consumption and investment demonstrated. At that meeting, members discussed rate hikes ranging between 25 and 50 basis points.

The main arguments in favour of a larger rate increase were these:

• The labour market was still very tight, a large share of firms were operating at peak capacity, and unemployment was low and had fallen between meetings.
• Generous wage rises in the recent past, together with other factors, had driven domestic demand.
• Medium- and long-term inflation expectations had been broadly unchanged in the recent term, even though inflation had fallen and the short-term inflation outlook had improved.
• Inflation expectations were well above target and appeared less firmly anchored to the target. Among other things, this could lead to insufficient resilience against the passage of cost increases through to the price level and could cause the benchmark for pay rises in the upcoming wage negotiations to be higher than it would be otherwise.
• The economy was still quite strong, albeit less so than had been forecast.
• The long-term inflation outlook was broadly unchanged since May, and the risk remained that inflation would continue to be persistent.
• Given these factors and the outlook for continued disinflation, the CBI’s real rate would probably have to be somewhat above the equilibrium real rate and would have to remain high for a longer period.
• An excessively loose monetary stance was riskier than an overly tight one, given the strong demand pressures in the economy.

The main arguments in favour of a smaller rate hike were these:

• The effects of monetary policy appeared to be surfacing, and the economy was less buoyant than previously forecast.
• A number of factors were reducing inflationary pressures, including the appreciation of the ISK, which had yet to pass through to the price level.
• Housing market activity had continued to subside, and the outlook was for a slowdown in private consumption in Q2. (This was subsequently borne out by SI data showing that private consumption had remained all but flat in Q2.)
• It was noted that a share of household mortgages were already being subjected to interest rate reviews, which would increase the affected borrowers’ debt service in the near future.
• Deposit interest rates had risen somewhat, which should encourage an increase in saving.
• Both factors should slow down demand, all else being equal.
• As a result, a large increase in the key interest rate might not be needed to raise the real rate.

Below is an overview of factors we expect the MPC to take into account as they consider next week’s interest rate decision:

Demand growth is losing steam …

As the MPC noted in August, there are clear signs that demand growth is easing in the domestic economy. In our newly published macroeconomic forecast, we project that GDP growth will measure 2.2% in 2023. This is a substantial slowdown relative to last year’s growth rate of 7.2%, as well as being far below our spring forecast. The downward revision is due mainly to weaker growth in private consumption and investment. We expect domestic demand, which is mainly a reflection of investment and consumption, to grow by only 1.3% this year, as compared with 6.6% in 2022. Export growth will be the main driver of output growth this year, while the contribution from domestic demand will naturally be much smaller than in 2021 and 2022.

For 2024, we forecast GDP growth to rise to 2.6%, owing largely to faster year-on-year growth in consumption, offset by weaker export growth and a marginal contraction in investment. The outlook is for 3.0% GDP growth in 2025, with growing domestic demand outweighing weaker export growth.

… but inflation is stubborn …

Inflation has risen slightly since the MPC’s August interest rate decision. When the Committee met in August, the July inflation measurement of 7.6% was the most recent available. Headline inflation measured 8.0% in September, however. Measures of underlying inflation show little change during this period, though.

Developments in inflation in Iceland versus neighbouring countries have diverged, and it looks as though high inflation will prove more difficult to dislodge here than in most other economies. This is due not least to Iceland’s stronger demand-driven inflationary pressures. This demand-generated inflation responds more readily to monetary tightening than inflation driven by cost pressures such as rising global fuel prices does.

… and inflation expectations are high

In August, the MPC was piqued by how high inflation expectations were despite the steep interest rate hikes in previous quarters. High inflation expectations are likely to cause workers to demand larger pay increases in a bid to protect their purchasing power, as well as providing tacit justification for firms to raise the price of their goods and services more than they might otherwise.

There has been no visible improvement in inflation expectations since the MPC’s August decision, and a more recent measurement of households’ and businesses’ expectations is not yet available. The long-term breakeven inflation rate in the bond market is well above the inflation target, however. We estimate the ten-year breakeven rate at around 4.5% at present. The calculated five-year breakeven rate five years ahead, which should exclude the impact of the current inflation spike, is around 4.2%.

But it is important to remember that part of the breakeven inflation rate is probably due to an uncertainty premium. The breakeven rate in the bond market is calculated by deducting the yield on indexed bonds (usually Treasury bonds) from the yield on nominal bonds of comparable duration. There is merit in the argument that long-term investors choose to guarantee themselves a certain real rate of return instead of exposing themselves to uncertainty about how much a given nominal rate of return will actually deliver. When inflation has been as volatile is it has been in Iceland and inflation expectations become less firmly anchored to the target, this uncertainty premium is likely to be higher. As a result, the breakeven rate is probably exaggerating inflation expectations in the market at present.

Will the MPC focus more on inflation expectations …

The MPC’s concerns about high inflation expectations are both logical and understandable. Nevertheless, it can be posited that if inflation expectations have become unmoored from the target, the link between monetary policy and inflation expectations is likewise weakened. Longer-term expectations then start to become affected more by short-term developments and prospects at any given time. In other words, the principle that inflation follows where inflation expectations lead becomes less unequivocally true, as the cause-and-effect relationship starts to work fairly strongly in the other direction as well.

It can therefore be concluded that the monetary stance – plus, hopefully, more favourable developments in external factors such as foreign prices – must have a clearer impact on short-term developments and prospects if it is to pull long-term expectations down into better sync with the CBI’s inflation target. As a result, we think it would be sensible under the current circumstances for the CBI to avoid focusing excessively on the gap between expectations and the inflation target and to pay equal attention to indicators of how monetary policy affects demand, asset markets, the proclivity to save, the ISK exchange rate, and other similar factors.

… or rising real rates?

If CBI officials are disappointed with the impact of monetary policy on inflation expectations, they must surely be cheered up a little by developments in the real rate. Although interest rate hikes have been underway ever since spring 2021, a tighter monetary stance as manifested in the real rate is a more recent development.

Ever since July, the policy rate has been higher than twelve-month inflation, which means that by that measure, the real policy rate is positive, after having been strongly negative from the onset of the pandemic until summer 2023.

But as we have discussed previously, this comparison between interest rates and past inflation is not a terribly illuminating measure of the actual monetary stance. It makes more sense to compare inflation expectations and the interest rate level, or simply to examine the real rates offered in the market. As the chart shows, the real rate in terms of these measures has risen considerably in recent quarters. For example, in terms of the average of various measures of one-year inflation expectations, the real policy rate measured -0.4% a year ago, had risen to just above zero by the beginning of 2023, and now stands at 2.3%, according to the most recent numbers. Indexed base interest rates have followed a similar pattern. The yield on indexed Treasury bonds with a ten-year duration was 1.5% a year ago and right around 2.0% in mid-2023 but is now up to approximately 2.9%. The monetary stance has therefore tightened significantly in recent quarters. This can also be seen in market agents’ responses to CBI survey questions about their views on the monetary stance. In August, nearly one-third of respondents considered the stance too loose, down from two-thirds in May, and the share who considered it too tight increased from 17% to 26% over the same period.

Policy rate hikes to conclude before the year-end?

Although MPC members made much of high inflation expectations and demand pressures in the economy at their August meeting, the tone in the Committee’s August statement and at the press conference following the interest rate decision was palpably milder than it had been earlier in the year.

We think it likely that the current spate of rate hikes will come to an end after next week’s expected increase to 9.5%. If the Committee decides to hold rates unchanged next week, it will be that much more likely to raise them at its meeting in late November, by which time the CBI will have prepared its new macroeconomic and inflation forecast. On the other hand, the CBI’s new forecasts could also provide solid support for a decision to keep the policy rate unchanged after the recent series of rate hikes – that is, if those forecasts are similar to our own most recent projections. If our newly published forecast of weaker growth in demand and declining inflation in coming quarters is borne out, we expect the policy rate to hold steady at 9.5% until Q2/2024. But there is little wiggle room if rate hikes are to stop at 9.5%.

Further ahead, the policy rate will fall again, perhaps starting in spring 2024 – provided that inflation develops in line with our projections. Thereafter, the policy rate will fall gradually as inflation eases and demand pressures subside. It could therefore be around 6% towards the end of 2025. This means that interest rates will be quite high in the coming term, as the outlook is for rather persistent inflation and relatively brisk growth in economic activity over the period.