Iceland pauses in easing campaign after 9 rate cuts

August 26, 2020

Iceland’s central bank paused in its aggressive monetary easing cycle after 9 rate cuts in the last 16 months but said it still had “the scope to response decisively to the deteriorating economic outlook” due to more firmly anchored inflation expectations.

The Central Bank of Iceland (CBI) left its rate on seven-day deposits at 1.0 percent after cutting it four times this year by a total of 200 basis points – most recently in May – and by 350 points after cutting it 9 times since May 2019 when the outlook for the North Atlantic island darkened.

“Lower interest rates, together with actions taken by the Bank this spring have supported domestic demand,” CBI said, adding the “impact of these measures has yet to emerge in full, however, and they will continue to support the economy and facilitate a more rapid recovery than would otherwise occur.”

Hit by a series of adverse events in 2019 – a hit to tourism from the collapse of a budget airline and the grounding of Icelandair aircraft, the failure of the capelin catch due to rising ocean temperatures and production difficulties in the aluminum industry – Iceland’s economy was already slowing before the outbreak of COVID-19 early this year.

In the first quarter of this year the country’s gross domestic product shrank 7 percent from the previous quarter, or by 1.2 percent year-on-year, and CBI estimated the economy would contract nearly 11 percent year-on-year in the second quarter.

In 2019 GDP slowed to only 1.9 percent growth from 3.8 percent in 2018.

“Although the outlook for H2 is rather poorer than was forecast in May, GDP is expected to contract by 7.1 percent in 2020 as a whole, instead of the previously projected 8%,” CBI said in its latest monetary bulletin, as household consumption didn’t suffer as much as previously feared.

Because economic developments were better than expected along with the government’s support, Iceland’s unemployment has not risen as much as feared and the unemployment rate this year is expected to average 7.2 percent instead of 8.7 percent as forecast in May.

In 2021 Iceland’s economic output is forecast to rise from its deep trough and expand by 3.4 percent and by the same in 2022 but first return to end-2020 level in late 2023.

In May CBI had forecast 2021 growth of 4.8 percent and then 2.8 percent in 2022.

After hitting a low of 1.7 percent in January, Iceland’s inflation rate has been accelerating to 3.0 percent in July – driven by a depreciation of the Icelandic krona – and is expected to average around 3.0 percent for the rest of this year, with medium and long-term inflation expectations anchored around the bank’s inflation target of 2.5 percent.

But with significant slack in the domestic economy and weak global inflation, inflation is forecast to taper off next year and average 2.4 percent after 2.6 percent this year and then to 1.9 percent in 2022.

After rising in the three years from May 2015, Iceland’s krona began depreciating in April 2018 and was also hit sharply in March, as most other currencies, as the pandemic-crises hit the global economy.

Today the krona was trading at 138.4 to the U.S. dollar, down 12.4 percent this year.

The Central Bank of Iceland issued the following statement:

“The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 1%.

According to the Central Bank’s new macroeconomic forecast, published in the August Monetary Bulletin, the outlook is for a 7% contraction in GDP this year and roughly 10% unemployment by the year-end. Although the outlook for H2 is somewhat poorer than was forecast in May, the contraction for the year as a whole is expected to be smaller than was projected then. This is due mainly to the more robust private consumption seen this spring and summer. Uncertainty is unusually pronounced, however, and economic developments will depend on the path the pandemic takes.

Inflation measured 2.5% in Q2 but had risen to 3% by July, driven largely by a more than 12% depreciation of the króna since the pandemic reached Iceland. Medium- and long-term inflation expectations are broadly unchanged, however, and appear to remain anchored to the Bank’s inflation target. According to the Bank’s forecast, inflation is expected to average about 3% over the remainder of 2020. However, because of the significant slack in the economy and low global inflation, it will taper off in 2021 and is projected to average 2% in the latter half of the forecast horizon.

More firmly anchored inflation expectations provide monetary policy the scope to respond decisively to the deteriorating economic outlook. Lower interest rates, together with actions taken by the Bank this spring, have supported domestic demand. The impact of these measures has yet to emerge in full, however, and they will continue to support the economy and facilitate a more rapid recovery than would otherwise occur.
The MPC will continue to monitor economic developments and will use the tools at its disposal to support the domestic economy and ensure that the more accommodative monetary stance is transmitted normally to households and businesses.”

www.CentralBankNews.info

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