The Central Bank of Iceland recently increased interest rates for the first time since the banking crash, amid renewed economic growth and higher-than-target inflation. Despite opposition from business and consumer groups within Iceland, the monetary policy committee had indicated the rate rise would probably only be the first of several.

The director of the central bank this morning explained that signs now point to higher economic growth in Iceland than previously expected and said that a lot would have to change for the bank to consider putting rates down again. They remain at 4.5 percent.

A statement released by the monetary policy committee states that the newest economic figures suggest that production growth and lowering unemployment have begun and that gradual interest rate rises are unlikely to stall that recovery.

On the other hand, the statement says, lower than expected inflation in August, a strengthening krona currency and the poor outlook on world economic markets meant that the committee did not feel it was appropriate to raise interest rates again right away.

Mar Gudmundsson, Director of the Central Bank of Iceland, told RUV that economic indicators look good. There is reasonable economic growth in Iceland predicted at around 2.5 percent — but will probably turn out to be higher than that with hindsight.

Gudmundsson said that the higher-than-hoped-for rate of inflation is reason enough to start hiking interest rates — but added that the overall picture is quite bright.

The current interest rate decision is influenced by opposing factors. On the one hand, the inflation outlook has deteriorated, at least in the near term, inflation expectations have drifted upwards, and real Central Bank rates have fallen significantly. Moreover, risks to the exchange rate outlook have increased in the aftermath of the Icesave referendum. On the other hand, the outlook for growth and employment has deteriorated according to the Central Bank’s baseline forecast published today in the Monetary Bulletin, with additional risk to growth stemming from the result of the referendum.

In spite of weaker activity, inflation expectations have risen recently and the medium-term inflation outlook has deteriorated. Headline inflation has increased for two consecutive months, to 2.3% in March. It is forecast to peak at just above 3% later this year and remain elevated until early next year. Higher inflation than previously forecast primarily reflects a weaker króna and the recent rise in commodity and oil prices. To the extent that these price increases are temporary, they are unlikely to have a lasting effect on longer-term inflation expectations and wage- and price-setting. Assuming a stable króna and given the spare capacity in the economy, inflation is forecast to fall back to target in the latter half of 2012. However, draft wage agreements imply pay increases that may prove larger over the medium term than is consistent with the inflation target.

The planned capital account liberalisation has limited short-term implications for the monetary policy stance because the first steps of the two-phase strategy should be broadly neutral in terms of their impact on the foreign exchange reserves.

The result of the Icesave referendum on 9 April has tilted risks to the exchange rate to the downside, as it may affect the sovereign credit rating and hence the terms at which Iceland can borrow in foreign capital markets. This may limit the MPC’s room for manoeuvre over the medium term. It may also affect the pace of capital account liberalisation. However, this is mitigated by the likelihood that the programme with the IMF will be unaffected.

The direction of future policy moves remains uncertain. The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

(Press release)

Headline inflation currently measures 1.9%. The near-term outlook is for slightly higher inflation than previously forecast in spite of some indications of weaker economic activity. This is due primarily to substantial increases in international commodity and oil prices, which need not signal higher inflation over the medium term provided that long-term inflation expectations and wage formation remain unaffected. Short-term inflation expectations have indeed picked up somewhat recently; however, inflation is still expected to be below target in coming months and to approach the target over the medium term.

While economic fundamentals and the capital controls continue to support the króna, the exchange rate has fallen by about 1% in trade-weighted terms since the MPC’s February meeting and by 5½% since peaking in November 2010. It is still too early to determine whether this development has been driven solely by temporary factors or whether the substantial narrowing of the risk-adjusted policy interest rate differential has also been a contributing factor.

Recently published GDP figures suggest somewhat weaker economic activity than previously expected. While domestic demand in 2010 turned out as expected, the contribution of net exports to growth was weaker than anticipated due to stronger imports, despite more robust export growth. Preliminary Statistics Iceland data therefore suggest a somewhat larger output contraction in 2010 than the Central Bank had previously forecast. However, early-vintage national accounts figures should always be interpreted with caution. On this occasion, strong imports of investment goods may signal stronger domestic demand than is indicated by the preliminary numbers.

The latest data on real economic developments, inflation, and the exchange rate provide somewhat conflicting guideposts for adjusting the monetary policy stance. In addition, the uncertainty stemming from the pending Icesave referendum and the fact that the capital account liberalisation strategy has not been finalised calls for extra caution at the current juncture.

With the prospect that inflation will remain near target and with interest rates at a historically low level, the direction of future policy moves remains uncertain. In addition, the prospect of removing the capital controls creates uncertainty about short-term room for manoeuvre. The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

(press release)

Inflation continued to subside in December and January. The CPI rose 1.8% year-on-year in January, or 1.6% excluding consumption tax effects, significantly below the inflation target of 2½%. One-off factors added to the seasonal drop in January. Favourable exchange rate developments over the past year, declining inflation expectations, and the slack in the economy continue to contribute to low and stable inflation.

According to the forecast published in Monetary Bulletin today, economic recovery will be somewhat stronger this year than was forecast in November. Output is forecast to grow by 2.8% in 2011 and by just over 3% in 2012 and 2013. Inflation has been slightly lower than was implied in the November forecast, due mainly to a one-off change in public services charges; however, according to the Bank’s forecast, it is expected to remain somewhat below the target until close to the end of the forecast period.

While economic fundamentals and the capital controls continue to support the króna, the exchange rate has depreciated by 4½% in trade-weighted terms since the MPC’s December meeting. It is too early to determine to what degree this development has been driven by temporary factors. Moreover, the Central Bank’s sizeable purchases of foreign exchange in December 2010, with the aim of reducing the banks’ foreign exchange imbalances and bolstering the Bank’s non-borrowed reserves, may have had some short-term effect.

With the prospect that inflation will remain near target and with interest rates at a historically low level, the direction of future policy moves becomes more uncertain. In addition, the prospect of removing the capital controls creates uncertainty about short-term room for manoeuvre. The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

September 16, 2010, Ministry of Economic Affairs

Central Bank of Iceland governor Mar Gudmundsson told reporters that the bank will begin regular currency purchases on the 31 August to strengthen its reserves.

He said at the press conference that inflation has been subsiding at a faster rate than predicted and the newest prediction is that it will fall to the Central Bank’s target level of 2.5 percent around the middle of next year.

He said that the economic news coming out of Iceland at the moment is generally positive; but added that interest rates are still a little high compared to the inflation outlook and the currency exchange restrictions and the recent decision of the Supreme Court on foreign currency indexed loans both add an element of uncertainty.

(Central Bank of Iceland press statement)

(Press Release)

Since the last MPC meeting, the króna has been broadly unchanged in trade-weighted terms but has appreciated against the euro. There has been no Central Bank intervention in the FX market. Sovereign risk premia have come down but are still high due to remaining uncertainty concerning Iceland’s medium-term access to global financial markets and possible contagion from the European sovereign debt crisis. Capital controls, current account developments, and the interest rate differential with major currencies continue to support the króna.

As expected, inflation picked up in February and March, partly due to unfavourable base effects, but resumed a downward trend in April. Inflation measured 8.3% year-on-year, or 6.9% excluding the impact of higher consumption taxes. According to the forecast published today, the medium-term inflation outlook remains broadly in line with the January forecast. As before, underlying inflation is expected to reach the target late this year. The contraction in the economy last year turned out smaller than previously forecast, with private consumption stabilising at an earlier stage of the cycle. Growth of fixed investment, on the other hand, will be weaker this year due to delays in aluminium sector-related projects and slower recovery of other business investment. As in January, the forecast is based on the assumption of a gradually strengthening króna, but on average it will be slightly stronger over the medium term than in the January forecast.

While a forecast of lower inflation in the context of a weak economy could be an argument for a larger reduction in interest rates, several opposing factors call for some caution. The recovery of the króna has been weak since the last interest rate decision. CDS spreads remain high, although they have come down significantly since early this year and were only modestly affected by the turmoil caused by Greece’s fiscal problems. While the credit rating outlook has stabilised, there is still residual uncertainty concerning Iceland’s access to global financial markets.

With the Second Review of the IMF programme in place, concerns about Iceland’s ability to service debt falling due in 2011 and 2012 should be alleviated. Hence, further delay in resolving the Icesave dispute is less likely than before to affect Iceland’s credit rating. The removal of capital controls, which have shielded the króna from the effects of delays in the past, would be risky, however, until access to further programme financing is guaranteed. Hence, the planned liberalisation of capital controls is likely to be delayed until an agreement is in place, or after the Third Review.

The uncertainty concerning Iceland’s future access to international capital markets continues to limit the MPC’s room for manoeuvre, albeit less so than before the Second Review. However, if the króna remains stable or appreciates, and if inflation develops as forecast, there should be some scope for continued gradual monetary easing. As always, the MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

“We decided to keep the interest rate unchanged at today’s meeting,” said the bank’s deputy governor Jan F Qvigstad. “Inflation and the level of activity may for a period be somewhat lower than anticipated. The analyses presented today indicate that the key policy rate should be raised gradually, but somewhat later than expected in autumn,” he added..

Qvigstad also stated that the Central Bank’s regional branches had indicated that output is rising gradually but, with some Norwegian industries still in decline, not at a pace to warrant any rate increases.

The Central Bank’s confirmation that the Asian market has shown strong growth was tempered by reports of the more moderate upswing across Europe.Interest rate expectations for the bank have declined abroad in recent months according to the Norway Post, with the comparative interest rates with other countries widening since autumn. This has brought unanticipated strength and stability to the Norwegian krone.

The bank believes that the strengthened currency, coupled with lower wage growth prospects, will exert further downward pressure on inflation in the future.
The Norwegian Central Bank Executive Board has declared that its strategy, barring any major economic shocks, will be to maintain the key policy rate within a 1.5-2.5 percent interval until June 23, when the country’s next Monetary Policy Report will be published.

Central Bank of Iceland press release:

Supporting an interest rate cut is the appreciation of the króna in trade-weighted terms since the last MPC meeting, despite the absence of Central Bank intervention in the FX market. This development, in an external environment of elevated sovereign risk premia and continued uncertainty about Iceland’s medium-term access to global financial markets, reflects the effectiveness of the capital controls and more favourable current account developments.

Inflation picked up in February, after a decline in December and January, to 7.3% year-on-year, or 5.9% excluding the impact of higher consumption taxes. The pick-up in inflation was broadly anticipated and does not fundamentally change the conclusion of the January forecast. Inflation is assumed to rise further year-on-year in March due to unfavourable base effects, but underlying inflation is still expected to reach the target late this year.

Elevated CDS spreads and a negative rating outlook associated with uncertainty about Iceland’s access to global financial markets support a relatively cautious move, due to potential negative pressure on the króna going forward. The delay in resolving the dispute over compensation of depositors in foreign branches of Landsbanki has triggered a sovereign credit rating downgrade to non-investment grade by one of the rating agencies and continues to delay the Second Review of the IMF programme and the associated financing. Given the continued effectiveness of the capital controls, this is not expected to have a substantial immediate effect on the exchange rate. However, in the absence of multilateral and bilateral financing or full access to international capital markets on acceptable terms, removal of capital controls or sizeable interest rate cuts would be risky until this matter is resolved.

If the króna remains stable or appreciates, and if inflation develops as forecast, there should be scope for continued gradual monetary easing. However, as long as there is significant uncertainty about Iceland’s future access to international capital markets, the MPC will have limited room for manoeuvre. As always, the MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.