CENTRAL BANK POLICY RATE Íslandsbanki Research

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1 CENTRAL BANK POLICY RATE Íslandsbanki Research Summary Our forecast: unchanged policy rate on 16 May Outlook broadly unchanged since March, when the MPC unanimously held the policy rate unchanged Unchanged policy rate in line with forward guidance and recent economic developments We forecast an unchanged rate through 218, followed by a 2-point reduction in 219 if inflation remains close to target Central Bank interest rate decisions Proposed Pro Policy rate unchanged for the time being We expect the Central Bank (CBI) Monetary Feb 18 Mar 18 May 18 / / / Policy Committee (MPC) to decide to hold the policy rate unchanged on 16 May, the next interest rate announcement date. The near-term economic and inflation outlook is broadly unchanged year-to-date. In its most recent decisions, the MPC has been unanimous in holding the policy rate unchanged, and there are few signs that developments in recent weeks will put a dent in that consensus. Con Preferred other Result Policy rate Feb 17 /. Mar 17 /. May 17-2 / Jun 17-2 / 2 (-) Aug 17 / 1 (-2) 4. Oct 17-2 / Nov 17 / 4.2 Dec 17 / 4.2 Arguments in favour of a higher rate Arguments in favour of a lower rate Robust private consumption growth Uncertainties in the labour market in coming quarters Higher inflation expectations/premia Need for continued monetary restraint Inflation expectations still close to target Housing market cooling Narrowing output gap Stable ISK Interest rate differential still substantial The forward guidance from the Committee will probably be neutral, as it has been recently. Headline inflation has fallen marginally since the MPC s last decision, while inflation expectations and the breakeven inflation rate in the bond market has inched upwards since the beginning of the year. The ISK has been stable, and indicators imply that tensions in the labour market and the economy as a whole are receding somewhat. The real policy rate has fallen slightly in the recent past, but the interest rate differential with abroad is still sizeable. Economic developments largely as expected Economic indicators year-to-date suggest relatively robust GDP growth in Q1. Total hours worked increased by 2.4% year-on-year in Q1, Icelanders payment card use was up more than 9% in real terms, and investment goods imports rose by over 8% in volume terms. 1

2 Demand for labour and GDP growth 1% 1% % % -% -1% -1-1% Source: Statistics Iceland GDP growth % Total hours worked, YoY change A number of factors imply, however, that demand pressures in the labour market and in the economy at large are easing. Unemployment was unchanged YoY in Q1, and the employment rate declined slightly. Furthermore, foreign nationals departures from Keflavík Airport increased by only 6% over the same period, and new motor vehicle registrations declined by just over 4% YoY in the first four months of the year. Real wage growth has also eased somewhat in the recent term, although it measured 4.6% YoY in Q Private consumption Card turnover, households Real wages Gallup CCI (r.axis) Source: Statistics Iceland, Central Bank of Iceland and Gallup Private consumption and related indicators Real YoY change (l.axis) and index (r.axis) In February, the CBI projected 218 output growth at just over 3%, somewhat more than we had assumed in our updated macroeconomic forecast. In March, the MPC considered developments in line with the CBI s forecast and the MPC s previous assessment. Developments since March should largely accord with this assessment by the MPC and, if anything, strengthen their conviction that the outlook is for diminishing demand pressures in the economy. FX market calm and peaceful The foreign exchange market has been well balanced since last autumn. Short-term exchange rate volatility increased markedly just after the capital controls were lifted but has subsided once again. In recent months, volatility in the ISK has been broadly in line with that seen in 216, even though the FX market is much freer now. By the same token, the ISK has fluctuated within a relatively narrow range since late last summer

3 ISK trade-weighted index, daily values and volatility Steps in easing of capital controls Lifting of capital controls announced 3% 2% 2% 1% 1% % 14 % Jan-1 May-1 Sep-1 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 May-18 ISK index (l.axis) 21d rolling avg of ISK index (l.axis) 21d annualized volatility (r.axis) Source: Central Bank of Iceland and ISB Research calculations In March, the MPC considered it positive that the foreign exchange market had remained well balanced. We share that opinion; indeed, it could be argued that the current exchange rate is close to some sort of short-term equilibrium. Presumably, developments since March will be satisfying to MPC members at the May meeting also and push the balance of opinion towards a lower rather than a higher policy rate. Inflation broadly unchanged, while inflation expectations inch upwards Since the MPC s last interest rate decision, headline inflation has taken a quick peek above the CBI s inflation target. It measured 2.8% in March, overtaking the target for the first time in four years. In April, however, it fell back below the target, measuring 2.3%, not least because of an unexpected month-onmonth drop in house prices. House price inflation has lost momentum in the recent past, which should be pleasing to the MPC. Headline inflation is virtually the same as at the time of the last policy rate decision, but recent developments show clearly how little is required to push it upwards when domestic cost pressures are no longer contained by a continually rising exchange rate. 4, Inflation forecasts (%) 3, 3, 2, 2, CBI inflation target 1, 1,,, Inflation CBI Feb-18 ISB Research May 18 prelim CBI Feb-18, constant indirect taxes Source: Central Bank of Iceland, Statistics Iceland and ISB Research The inflation outlook for coming quarters is quite good, in our opinion. We agree with the CBI s assessment, published in its February forecast, that inflation will hover around the target for the remainder of the decade. There are some clouds on the horizon regarding wage costs next year, however, as a large majority of the private sector wage agreements currently in effect expire at the end of this year, and the tone from many labour movement leaders has been quite assertive. 3

4 4,% Inflation premia vased on treasury yield curves 3,% 3,% 2,% 2,% Inflation target 1,% 1,%,% Rate decision days,% Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 3 year year 1 year Rate decision Source: Kodiak 3 and year ISB Research calculations year 1 year Rate decision The breakeven inflation rate in the bond market has been largely unchanged since the last interest rate decision. It now lies in the % range in terms of the yield curve on 3- to 1-year Treasury bonds, noticeably above the inflation target, as it was at the time of the last interest rate decision. Most other measures of inflation expectations have also risen this year. They remain close to the inflation target, however, therefore reflecting executives, market agents, and households opinion that inflation will be moderate in coming years. As yet, the rise in inflation expectations need not be a source of grave concern for the MPC, although it would indeed be better for monetary policy if expectations were at the target. In March, Committee members considered it premature to conclude that the increase meant that inflation expectations were becoming unmoored from the target. It will be interesting to see how they interpret recent developments. The real policy rate has fallen Since the MPC s last decision (in mid-march), the real policy rate has fallen by most measures. In terms of the simple average of various measures, it is now around 1.%, down from 1.7% at the time of the March rate-setting meeting and 2.9% in mid-217. It has therefore fallen steeply in the past year. A decline in the real policy rate is normal given the various indicators that the economy is slowing and monetary policy credibility withstood the stress test represented by the removal of capital controls in March 217. On the other hand, it is difficult to determine whether the past year s drop in the real policy rate is of an appropriate scale in view of current economic conditions. That said, we consider the current monetary stance reasonably suitable., 4, 3, 2, 1, CBI real policy rate by various estimation methods, jan14 júl14 jan1 júl1 jan16 júl16 jan17 júl17 jan18 12m trailing inflation Bond market inflation premium Inflation expectations, consumers Inflation expectations, businesses Inflation expectations, market participants Source: Central bank of Iceland, ISB Research calculations 4

5 In March, the MPC noted that the real policy rate had fallen slightly between meetings and discussed whether the monetary stance was appropriate. Clearly, the Committee concluded that it was, but the drop in the real policy rate since then could occasion concerns among some members when next week s decision is made. 7 Inflation, policy rate and real policy rate (%) Jun-14 Dec-14 Jun-1 Dec-1 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Effective CBI policy rate Inflation Real policy rate Source: Central Bank of Iceland, Statistics Iceland and ISB Research forecast Probability of a slight reduction in interest rates during the coming year In our opinion, rising inflation will continue to push the real policy rate downwards in coming quarters, all else being equal. But given the generally favourable inflation outlook and the expectation that the economy will slow down a bit over time, it is not impossible that the CBI will lower the policy rate further ahead, as demand pressures subside and the inflation outlook remains stable. A small reduction in the nominal policy rate next year is therefore not out of the picture, in our opinion. If inflation rises significantly above target in the coming year, however due to large wage rises, continued pressure in the housing market, and/or a depreciation of the ISK the CBI will hardly lower the policy rate further, and it could even decide to signal the possibility of rate hikes as the winter advances.

6 Author Jon Bentsson, chief economist LEGAL DISCLAIMER This report is compiled by Islandsbanki Research of Islandsbanki hf. The information in this report originates in domestic and international information and news networks that are deemed reliable, along with public information, and Islandsbanki Research s own processing and estimates at each time. The information has not been independently verified by Islandsbanki which therefore does not guarantee that the information is comprehensive and accurate. The views of the authors can change without notice and Islandsbanki holds no obligation to update, modify or amend this publication if assumptions change. This publication is only published for informational purposes and shall therefore not be viewed as recommendation/advice to make or not make a particular investment or an offer to buy, sell or subscribe to specific financial instruments. Islandsbanki and its employees are not responsible for transactions that may be carried out based on information put forth in the report. Before making an investment decision, recipients are urged to seek expert advice and get well acquainted with the investments market and different investment alternatives. There are always financial risks related to investment activities, including risk due to international investments and fluctuations in the exchange rate of currencies. Investors investment objectives and financial position vary. Past performance does not indicate nor guarantee future performance of an investment. The research report and other information received from Islandsbanki are meant for private use only. The materials may not be copied, quote or distributed, in part or in whole, without written permission from Islandsbanki. This report is a short compilation and should not be considered to contain all available information on the subject it discusses. Supervisory body: The Financial Supervisory Authority of Iceland ( UNITED STATES This report or copies of it must not be distributed in the United States or to recipients who are citizens of the United States against restrictions stated in the United States legislation. Distributing the report in the United States might be seen as a breach of these laws. CANADA The information provided in this publication is not intended to be distributed or circulated in any manner in Canada and therefore should not be construed as any kind of financial recommendation or advice provided within the meaning of Canadian securities laws. OTHER COUNTRIES Laws and regulations of other countries may also restrict the distribution of this report. Further information regarding material from Islandsbanki Research can be accessed on the following website: 6