Iceland's central bank maintained its policy rates and has decided to resume regular purchases of foreign currency, with the amount purchased re-evaluated in the autumn, or earlier if circumstances warrant it.
The Central Bank of Iceland also said that due to the decline in inflation and inflation expectations, "the slack in the monetary policy stance has probably disappeared" and "increased growth in domestic demand in the near term will probably require further increases in the Bank's real interest rate, other things being equal."
"Whether this requires a change in the Bank's nominal interest rates in the near future will depend on developments in inflation and inflation expectations," the bank said, confirming its guidance from last month.
The central bank has held its benchmark seven-day lending rate steady since November 2012 and raised its growth forecast in May while it lowered the inflation forecast due to the stronger Icelandic krona and smaller rises in labour costs than previously expected.
In May the central bank said it expected economic slack to disappear by mid-2014.
Iceland's inflation rate rose slightly to 2.4 percent in May from 2.3 percent in April after averaging 2.5 percent in the first quarter, and thus remains close to the central bank's 2.5 percent target.
The bank said it expects inflation to remain near its target until next year when it is forecast to rise as a positive output gap emerges. Inflation expectations one to two years ahead have declined somewhat recently but long-term expectations are still above target, the central bank said.
In May the central bank forecast 2014 inflation of 2.5 percent, down from a forecast of 2.7 percent in February, and forecast 2015 inflation of 3.1 percent and 2016 inflation of 3.3 percent.
Domestic demand in the first quarter of 2014 was somewhat stronger than the central bank had expected but overall growth in output was "markedly weaker" than forecast in May due to strong imports of services. But it added that interpreting first quarter output data is always difficult to interpret due to wide fluctuations in export inventories.
Iceland's Gross Domestic Product contracted by 0.7 percent in the first quarter from the previous quarter for annual shrinkage of 0.1 percent, down from 3.8 percent year-on-year growth in the fourth quarter of 2013.
Last month the central bank revised its growth forecast upwards, with 2014 GDP seen rising 3.7, up from 2013's 3.3 percent and the February forecast of 2.6 percent. Growth in 2015 is seen at 3.9 percent and 2016 growth of 2.7 percent.
After plunging in 2008, the Icelandic krona has appreciated since November 2013 and the central bank said its foreign exchange intervention had led to greater stability over the past 12 months, with the season generally associated with strong foreign currency inflows still ahead.
"The Bank has therefore decided to resume regular foreign currency purchases," the central bank said, intervening to mitigate exchange rate volatility.
The krona was trading at 114.2 to the U.S. dollar, slightly up from 115.1 at the end of 2013 but sharply up from 128.0 at the end of 2012.
Iceland is still trying to exit capital controls that were imposed in 2008 and last month the finance minister warned that the three banks of Kaupthing, Glitnir and Landsbanki could be put into bankruptcy if creditors do not agree on haircuts as part of a deal worth some US$ 22 billion to wind up the the three banks debts that collapsed under debt of more than $75 billion.
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