Understanding the CBI’s Monetary Policy

The Central Bank of Iceland (CBI) is set to release a new inflation forecast in its Monetary Bulletin on November 19, alongside its upcoming interest rate decision. This forecast is expected to paint a bleaker picture of next year’s economic developments compared to the August forecast, which predicted a GDP growth rate of just over 2% in 2026. The revised outlook will likely grab the attention of the Monetary Policy Committee (MPC) during the decision-making process and may provide the strongest argument for a policy rate cut.

The CBI’s Primary Objective

It’s essential to note that the CBI, unlike the US Federal Reserve, has a single monetary policy mandate: to keep inflation as close to the target as possible. As long as financial stability and domestic financial security are not threatened, the battle against inflation takes priority. MPC members have expressed their willingness to push the economy into a hard landing if that’s the only way to achieve the 2.5% inflation target. In our assessment, as long as inflation remains stubborn and inflation expectations are not aligned with the target, it would not enhance monetary policy credibility for the Committee to respond to a poorer economic outlook by lowering interest rates now.

Challenges in Combating Inflation

The fight against inflation has proven to be a longer and more challenging battle than anticipated. Headline inflation currently stands at 4.3%, nearly 2 percentage points above the CBI’s target and above the upper tolerance limit. Inflation has remained rooted at around 4% for most of the year, with only a few isolated monthly fluctuations.

Rising Inflation Metrics

Another cause for concern is the increase in various inflation metrics beyond the Consumer Price Index (CPI). For instance, the CBI Governor has noted that inflation in terms of the CPI excluding housing (CPIXH) was previously near the target. However, CPIXH inflation has now risen to 3.3%, its highest since August 2024, and has increased by half a percentage point in the past two months. Similarly, inflation according to the Harmonised Index of Consumer Prices (HICP) and Statistics Iceland’s (SI) core indices has also picked up over the past twelve months. These metrics are not aligned with the target, indicating that inflation remains a significant challenge.

Conclusion

In conclusion, the CBI’s upcoming inflation forecast is expected to reveal a more pessimistic outlook for next year’s economic developments. While this may lead to calls for a policy rate cut, the CBI’s primary objective of combating inflation must take priority. With inflation remaining stubborn and inflation expectations out of sync with the target, it’s crucial for the MPC to maintain its focus on achieving the 2.5% inflation target, even if it means pushing the economy into a hard landing. The CBI’s commitment to its mandate will be essential in ensuring the long-term stability and security of Iceland’s financial system.