Iceland holds rates, sees tightening as economy improves

    The Central Bank of Iceland kept interest rates unchanged but said the recovery of the domestic economy continues to gain momentum, despite a weaker global outlook, and it would be necessary to tighten policy further as spare capacity disappears.
    The Icelandic central bank, which has already raised its benchmark overnight lending rate by 100 basis points to 6.75 percent this year, said the degree of tightening of interest rates towards "normalisation" would depend on how inflation evolves.
    "The accommodative monetary stance has supported the economic recovery," the bank said in a statement following a meeting of its monetary policy committee.
    "The interest rate increases in May and June, together with reduced inflation, have withdrawn some of that accommodation. As spare capacity disappears from the economy, it is necessary that monetary policy slack should disappear as well," the bank added.

    The bank said the outlook for output growth was "somewhat stronger" than forecast in May but the outlook for 2013 and 2014 was largely unchanged. The labour market had recovered stronger than expected and the economic recovery continues to gain momentum though the global economic outlook remains uncertain which creates potential headwinds for the economy and inflation.
    The central bank raised its forecast for 2012 GDP growth to 3.1 percent, up from May's forecast of 2.6 percent, due to stronger exports. For 2013 growth is forecast at 2.2 percent, down from May's 2.8 percent forecast and in GDP is forecast to grow by 3.4 percent, up from 2.7 percent.
    In 2011 the Icelandic economy expanded by 3.1 percent. 2014 by 3.5 percent.
    The 2008 financial crises hit Iceland very hard with its banking sector collapsing as its three major banks could not refinance their short-term debt. The International Monetary Fund, together with several other countries, put together a loan package and two of the country's major banks are now owned by foreign banks.
    The outlook for inflation in Iceland over the next two years has improved due to an 8 percent rise in the Icelandic krona's trade-weighted index since the May forecast.
    The bank forecasts average inflation of 5.4 percent this year, easing to 3.4 percent in 2013 and 3.0 percent in 2014. In July inflation eased to 4.6 percent.
    But the central bank cautioned that inflation was not expected to reach its 2.5 percent target until then end of the two-year period and long-term inflation expectations remain far above target.
    But the outlook remains uncertain and a further rise of the krona could push down inflation faster and it is uncertain how much for the recent appreciation would be maintained during the winter.

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