Long line of Iceland interest rate cuts comes to an end

(Central Bank of Iceland press release): The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The deposit rate (current account rate) will remain 3.25%, the maximum bid rate for 28-day certificates of deposit (CDs) 4.0%, the seven-day collateralised lending rate 4.25%, and the overnight lending rate 5.25%.

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.