05.09.2007

Iceland Daily: 5 September 2007

Market Comment – Further delays in the cutting cycle?

The Central Bank of Iceland will announce its policy rate decision tomorrow (6 September) at 9:00 GMT. Kaupthing Research expects the bank to maintain its policy rates unchanged at 13.30%, the fifth meeting in a row. However, the Central Bank (CB) will most probably express worries about the recent acceleration of private consumption that seems to apparent in most indicators. The CB might also hint at a delay in the cutting cycle that was previously set to start in March next year due a greater underlying inflationary pressure. 

 Inflation in the pipeline: Wage increases ahead
In Research's opinion, the short-term inflation outlook has worsened considerably since the CB's last policy rate decision meeting. According to Research's policy rate forecast, the CB will start lowering its policy rate in May 2008 and not in March, as stated in the CB's baseline forecast, published in July.  One can expect the next baseline forecast, which the Central Bank will publish in its Monetary Bulletin in November, to show a slower policy rate reduction process.  As can be gleaned from Research's recent inflation forecast, one of the main factors behind the worsening inflation outlook is the excessive tension on the labour market.

 Outlook is brighter over the longer term
Contrary to the gloomy short term view, Research believes that demand will contract in the economy in 2008 so that the inflation outlook for the longer term is relatively brighter. We therefore expect a fairly rapid decreasing process in the policy rate in the latter half of 2008 – not least because the policy rate in real terms will be very high by then.  One can expect the CB's policy rate to reach its lowest point in 2009 and that the subsequent upturn in the economy, due to, among other things, public and hydropower and aluminium sector investments, will limit any further policy rate reductions.

 Policy rate high in real terms despite high inflation
According to Research's policy rate and inflation forecasts, the Central Bank's policy rate in real terms will remain high long into 2008. Looking at the policy rate in real terms for each quarter, one can expect it to fall at the end of 2007, due to considerably higher inflation in the last quarter of the year. If one looks at policy rates in the context of inflationary expectations, the picture looks rather different. Looking at the policy rate in real terms in Research's current inflation forecast for the next twelve months, in each case the policy rate in real terms is higher in 2008 than was stated in the previous forecast. The reason for this is that, even though the short-term inflation outlook has worsened, according to the forecast, the long-term outlook is now better; to be more precise our new inflation forecast is lower from the third quarter of 2008 onwards than it was in the previous forecast. In addition to this, we now expect a slower policy rate reduction process in 2008 than previously envisaged.

Market Comment – Iceland's current account in Q2

 Current account deficit in Q2 was 17% of GDP  - In line with our forecast
Iceland's current account deficit in Q2 2007 amounted to 51 bn ISK which equals 17% of GDP. The data was released by the Central Bank of Iceland after the closing of markets today. As expected, the deficit increases significantly between quarters but the deficit was unusually low in Q1. Iceland's current account deficit reached a record high in 2006 and amounted to 25% of GDP at the same time last year.

Deterioration of trade balance
One of the main explanations for the rise in the current account deficit in Q2 is a higher trade deficit which amounted to 11% of GDP, compared to 3% in Q1. The trade deficit in Q1 was unusually low, mainly due to irregular components such as exports of airplanes. In Kaupthing Research's view, however, the trade deficit will shrink in H2 of 2007 as investments drop and private consumption slows down.

Volatility of the factor income balance
The factor income balance in Q2 amounted to ISK 7,6 bn which equals 2,6% of GDP. In comparison, the factor income balance in Q1 was 3% of GDP. The factor income balance is by far the most volatile component of the current account and the least predictable. To some extent, the factor income deficit expresses the worsening debt position of the Icelandic economy and the gap between registered in- and outflows of interest payments. However, this gap is probably overstated by the factor income balance due to measurement problems.

We expect an improvement due to a slowdown in aluminium investments
Kaupthing Research expected  the current account deficit to contract from the previous year in 2007, down to 17% of GDP. The improvement over the coming semesters  will primarily be driven by a turnaround in the trade deficit as imports related to aluminum investments slow down. Exports will furthermore increase considerably, mainly due to increased aluminum exports.