We project that the Monetary Policy Committee (MPC) of the Central Bank (CBI) will decide to cut interest rates by 0.25 percentage points on 6 November, its next rate-setting date. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore be 3.0%, down from 4.5% at the beginning of this year. It is not impossible that the MPC will decide to hold rates unchanged, but we think that if it does so, it will lower them in the next few months.

At its last meeting, in early October, the MPC voted unanimously to lower the policy rate by 0.25 points. It was the second time in a row that all members agreed on a rate cut. But unlike the previous meeting, held in August, the Committee also discussed the possibility of keeping rates unchanged in October. In August, a rate cut was the only option on the table, and apparently, none of the Committee’s members seriously considered the possibility of keeping rates unchanged.

Among the grounds cited for keeping the policy rate unchanged, the MPC mentioned several points: the economy had been stronger than expected in H1, inflation expectations were above target by some measures and underlying inflation had inched upwards, more accommodative fiscal policy meant that less monetary easing was required, and public sector wage agreements had yet to be finalised.

But were several arguments in favour of a rate cut, too: inflation expectations had continued to fall, there was the risk that the GDP growth outlook was overestimated (particularly in view of the erosion of the global outlook), and the short-term inflation outlook had improved. The latter set of arguments obviously outweighed the former in October.

The forward guidance in the MPC’s October statement was neutral – indeed, it was a verbatim repetition of the guidance from August:

Near-term monetary policy decisions will depend on the interaction between developments in economic activity, on the one hand, and inflation and inflation expectations, on the other.

It can be inferred from this that in November, the MPC will pay close attention to October inflation figures, developments in the breakeven inflation rate in the bond market, and last week’s market expectations survey. The Committee will also consider high-frequency indicators such as payment card turnover, sentiment indices, and labour market data.

This time, we expect moderate inflation expectations, an improving short-term inflation outlook, and signs of a cooling economy to outweigh factors such as brisk real estate market activity, a smaller interest rate differential with abroad, and uncertainty about public sector wage negotiations.

Economy continues to cool

Recent indicators of developments in domestic demand suggest that the economy has continued to cool along with the weather. Payment card turnover figures show that Icelanders are clutching their wallets a bit tighter than they did earlier in the year. Payment card turnover was virtually unchanged in real terms in Q3, which hasn’t happened since the beginning of 2013.

Other indicators of private consumption tell the same story. Real wages grew by only 1.1% YoY in Q3, the slowest growth rate in over six years. And on average, consumer expectations have been considerably lower in 2019 than in previous years. Finally, unemployment has risen and job creation has weakened relative to previous years, and the recent survey conducted by the CBI and the Confederation of Icelandic Employers shows a significant drop in worker shortages among large companies.

This survey also suggests a marked contraction in business investment this year – in most sectors apart from fishing – and that the contraction will be most pronounced in tourism and construction. This is in line with our recent macroeconomic forecast, where we project that business investment will contract this year by just over 16% and total investment by over 6% year-on-year.

But not all indicators point unequivocally towards a cooling economy. The housing market appears relatively buoyant, with house prices up 4.2% year-on-year according to Statistics Iceland’s October measurement – the strongest increase since June. The CBI, in its recent Financial Stability report, pointed out that commercial property prices have continued to rise in recent months, noting that falling interest rates have stimulated demand in the market.

The CBI will publish a new macroeconomic forecast concurrent with the 6 November interest rate decision. In August, the bank forecast that GDP would contract by 0.2% this year and then rebound to 1.9% growth in 2020. In light of recent developments, we would not be surprised if the new forecast proved rather more upbeat about 2019 and more lukewarm about 2020.

Inflation expectations in line with the target

Inflation has lost considerable momentum year-to-date, measuring 2.8% in October, after peaking at 3.7% at the end of 2018. It is now at its lowest in just over 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 August, the CBI projected that inflation would average 2.9% in Q4/2019 and would not align with the target until Q2/2020. Given the recent developments in inflation and the ISK exchange rate, we expect next week’s inflation forecast to be somewhat more optimistic.

Alongside the uptick in inflation in H2/2018, inflation expectations rose by all measures, although long-term expectations rose less strongly. In 2019 to date, however, expectations have fallen steadily, and long-term expectations are now within striking distance of the CBI’s target by all measures. This will give the bank more latitude than it has often had before to ease the monetary stance in response to a bleaker economic outlook.

Developments in the breakeven inflation rate in the bond market should prove palatable to the MPC, too, as the breakeven rate has declined substantially year-to-date. In recent weeks, the medium-term breakeven rate has been at 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.

Scope exists for a low real policy rate

Although the nominal policy rate has been lowered by 1.25 percentage points so far this year, the real policy rate has fallen much less steeply, owing to declining inflation and inflation expectations. In September, the real policy rate ranged between 0.5% and 1.0%, depending on the measure used.

The range is virtually the same as at the beginning of the year. The October rate cut went hand-in-hand with the drop in inflation and the breakeven inflation rate, which means that the real policy rate has not changed to any significant degree.

Given the favourable inflation outlook, modest near-term inflation expectations, and the deepening slack in the economy, there should still be room to ease the monetary stance by lowering the real policy rate.

Interest rate differential with abroad has narrowed

This year’s marked decline in domestic long-term interest rates has narrowed the interest rate differential with abroad even though long-term rates in other economies have also been trending downwards. This month, the spread on 10-year government bonds has averaged 3.9% against the euro, 2.8% against the pound sterling, and 1.7% against the US dollar, as compared with 5.2% (EUR), 4.1% (GBP), and 2.7% (USD) in January.

The MPC has often taken note of the interest rate differential. It can be argued, however, that the spread is narrowing at present, as Iceland’s economic and inflation outlook is now better aligned with trading partners than it has been in the recent term.

Is the policy rate bottoming out for now?

We expect that, after lowering the policy rate next week, the MPC will keep it unchanged until end-2020. On the other hand, if the Committee decides to keep the policy rate unchanged next week, a rate cut in December will become more likely. 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.