Yesterday the Icelandic central bank Sedlabanki hiked its key policy rate by 50bp to 5.50%. The hike was fully expected by the markets and is the second hike this year.

I don’t have much time to write about this, but let me just briefly say that I think there are very good reasons for Sedlabanki to hike rates – in fact it looks as if Sedlabanki is even falling behind the curve and more rate hikes might be warranted.

Overall I think there are three very strong reasons for tightening monetary conditions in Iceland:

1) I have earlier argued that Sedlabanki since Mar Gudmundsson became governor in July 2009 has had a de facto 4.5% nominal GDP target (See here after 50:03). Hence, until recently NGDP was kept on a 4.5% path, but over the past year or so NGDP growth clearly has accelerated and Sedlabanki now forecasts NGDP growth of 10.6% in 2015, which clearly is far too strong and is not consistent with Sedbanki’s 2.5% inflation target.

2) It is always extremely useful in the conduct of monetary policy to keep an eye on market expectations and here the signal is very, very clear. Recently inflation expectations have increased rather dramatically and both 2, 5 and 10 year breakeven inflation rates are now around 4.5% inflation – way above Sedlabanki’s 2.5% inflation target.

3) Money supply growth is picking up and (unadjusted) M3 growth is now approaching 15%, which sends a clear signal that inflation and nominal GDP growth could pick up even further. The adjusted M3 numbers, which probably is a more truthfully indicator of inflationary pressures have accelerated to above 5%, which also indicates increased inflationary pressures.

So all in all I think it is very justified to hike interest rates for Sedlabanki and more is certainly needed to bring NGDP growth back towards 4-4-5% and reduce inflation expectations back towards Sedlabanki’s inflation target.

One thing I have noted is that while I here focus on nominal variables and on expectations Sedlabanki is more focused on the labour market situation and the recent wage agreements.

To me the wage agreements is not the cause of inflation, but rather a symptom of high inflation expectations and hence an overly easy monetary policy. That said, I do think that the Icelandic labour market system tend to create an inflationary bias in monetary policy (It is back to the old rules vs discretion debate). But I have to return to that topic in a later post…

PS it is rather incredible that Iceland after a massive banking crisis in 2008-9 now is one of the very few countries in Europe with robust nominal spending growth and a need for monetary tightening. Well done – now make sure not to repeat the mistakes of earlier days.

PPS big news out of Kazakhstan this morning – the central bank has floated the tenge. I strongly believe that this is the right decision on part of the Kazakh authorities. Pegged exchanges is generally not a good idea for commodity exporters (unless they peg to the export price).

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