The Monetary Policy Committee (MPC) of the Central Bank of Iceland (CBI) has decided to lower the Bank's key interest rate by 0.25 percentage points, from 4% to 3.75%. The decision is in line with analysts' expectations, as all public forecasts expected a rate cut. Despite being short, the statement of the MPC is full of treats. The main rationale, and in fact the only one mentioned for the rate cut, is tightening monetary stance between meetings due to falling inflation expectations. This is the last policy rate decision by Már Guðmundsson, at least in the role of the Governor. Government bond yields increased by 5-10 points today, as the market seems to have hoped for an even softer tone from the MPC.
Central Bank’s real rate played a key role in the decision, as the increase in the real rate in terms of the average of various measures of inflation and one-year inflation expectations outweighed the worsening inflation outlook. It’s interesting to see the MPC mentioning the CBI’s inflation forecast in the statement, hinting that the forecast is too optimistic given the recent depreciation of the ISK. If inflation increases beyond the CBI’s expectations, it may reduce the monetary policy’s scope to respond to the economic contraction, especially if inflation expectations start to creep up again. Nonetheless, we expect the MPC to continue to lower interest rates in the second half of the year, even though the tone and forward guidance is not as soft as we anticipated in advance.
Sources: CBI, Kodiak, Confederation of Icelandic Enterprise, Arion Research
The MPC is especially focused on the economic outlook, unsurprisingly, as every public forecast expects an economic contraction this year. Last May the CBI published its first economic forecast after WOW air’s bankruptcy. According to the forecast GDP is expected to contract by 0.4% in 2019, coupled with rising unemployment and slower growth in domestic demand. The MPC states that the most recent data on economic development do not change that view, as evidence of stronger private consumption growth than anticipated offsets the outlook for deeper contraction in tourism.
At the briefing this morning, the Deputy Governor stated that payment card turnover figures and business expectations indicate greater resilience in domestic demand than previously expected. We share this view, as Icelander’s total payment card turnover increased by 2.3% YoY in April and May and business expectations for the next few months have improved slightly. Therefore, it seems like Q2 will outperform expectations when it comes to private consumption. That being said, we expect that the latter half of the year will prove to be tough for households and businesses, especially when tourism’s high season comes to an end. The CBI’s private consumption forecast of 1.6% growth this year, is therefore, in our opinion, not an unlikely outcome. When it comes to tourism, we still believe the CBI’s forecast of 10.5% drop in tourist arrivals to be too optimistic. The CBI’s alternative forecast, which is based on 15% decline in tourist arrivals and predicts a 1.2% economic contraction this year, is still a more likely outcome in our view at this time.
Sources: CBI, Statistics Iceland, Arion Research. * Payment card turnover in Q2 2019 is estimated from turnover in April and May.
The MPC states that as of yet, inflation has been in line with the Bank’s last forecast, but further depreciation of the króna could change these prospects. According to CBI´s forecast inflation will on average stand at 3.4% in Q2 and Q3 of this year before sliding down to target before year end 2020. We feel that the MPC is hinting that this forecast may prove to be too optimistic. Arion Research´s preliminary inflation forecast is that inflation will be more persistent. The CBI will publish updated economic outlook in August, and if the bank shares our view, it effectively eases the stance of the monetary policy, leaving less room for rate cuts.
Sources: CBI, Statistics Iceland, Arion Research+
How this will eventually play out rests mostly on the development of exchange rate. EUR/ISK is currently 4.2% higher (weaker ISK) than what the CBI assumed would be the average exchange rate in 2019 in its most recent economic outlook, published on 22 May. The ISK depreciated somewhat on the back of numbers showing a 24% decline in tourist arrivals in May, with numbers for the first five months of 2019 showing a decline of 11.2%, with the full effect of WOW air´s bankruptcy since end of March.
The CBI’s economic forecast is based on a 10.5% drop in tourist arrivals in 2019, which we feel is too optimistic and likely to be revised in the bank´s August economic outlook. Additionally, most recent figures on foreign investment in domestic securities suggest a lesser foreign investment in ISK rates than might have been anticipated following the lowering of reserve requirements to 0% in early March, maybe due to lower interest rate difference. A net outflow of liberated offshore ISK amounting to around 15 bn. in March to May was by our estimates only met by CBI´s investment of around half of that amount. On the flip side of lower foreign capital inflow we expect a slower pace of foreign investments of pension funds, better outlook on current account surplus and CBI´s increased willingness to intervene in the FX market should the ISK continue to slide. The ISK has in recent weeks depreciated below our forecast and a further depreciation is not in our opinion supported by economic fundamentals. Short-term development will as usual be subject to the abovementioned currency flows.
In its two recent rate cuts the MPC has trudged along the Taylor curve. Although the Taylor curve has not proven to be complete tool for forecasting MPC rate decisions we believe that the committee keeps an eye on the curve. The curve below, which is based on the CBI´s most recent economic forecast, suggests that further 75 bps rate cuts could be on the horizon before year-end. However, mounting effects of weaker ISK on inflation outlook could reduce the MPC’s legroom for rate cuts. On the other hand, the output gap can easily narrow further than CBI anticipated in its most recent economic outlook, especially due to larger contraction in the tourism sector. Looking ahead it is not clear which will weigh heavier in coming MPC´s decisions. Although we feel that further rate cuts are likely we don’t anticipate cuts as large as 75 bps for the remainder of the year.
Sources: CBI, Arion Research. * Real neutral interest rates are 3% until mid-2015 and get gradually lower thereafter.