The Central Bank of Iceland, which has raised its rates by 100 basis points this year, said how much and when it would hike rates would depend on future developments, such as fiscal policy, while a strong krona and global price developments had provided scope to raise rates slower than previously considered necessary.
While holding rates steady today, the central bank raised its reserve requirements by 200 basis points to 4.0 percent as of Oct. 21 to "strengthen the Bank's liquidity management, in the wake of substantial foreign currency purchases" in connection with a wind-up of the estates of failed banks and the plan to release or tie up offshore krona.
Iceland's inflation rate remains below the bank's 2.5 percent target, partly due to the high exchange rate of the krona, helping improve the short-term outlook. In August inflation eased to 1.9 percent from July's 2.2 percent.
"As before, the outcome of wage settlements and somewhat elevated inflation expectations indicate that inflation will gain momentum in the near future," the bank said, adding this has been offset by falling global goods prices and nearly 4 percent appreciation of the krona since the last rate decision in August despite "sizable foreign currency purchases by the Central Bank."
In August, when the bank last raised its rate, it also raised its forecast for 2015 inflation to 2.2 percent from May's forecast of 1.9 percent, and the 2016 forecast to 4.3 percent and the 2017 forecast to 4.1 percent.
The Central Bank of Iceland issued the following statement:
"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5.5%.
During the first half of the year, domestic demand growth was broadly in line with the Central Bank’s August forecast, but GDP growth measured much stronger. Although the forecast error probably reflects temporary factors, the outlook is for continued robust GDP growth and a widening positive output gap in the coming term.
Inflation is still below the Bank’s inflation target – particularly if the housing component of the CPI is excluded – and has risen more slowly than was assumed in the Bank’s last forecast. This is due in part to the higher exchange rate of the króna, but volatile items play a part as well. As a result, the medium-term inflation outlook has not changed markedly, although the short-term outlook has improved. As before, the outcome of wage settlements and somewhat elevated inflation expectations indicate that inflation will gain momentum in the near future. This is offset by falling global goods prices and a nearly 4% appreciation of the króna since the last interest rate decision date, in spite of sizeable foreign currency purchases by the Central Bank.
If inflation rises in the wake of the wage settlements, as forecasts indicate, the MPC will have to raise interest rates still further in order to bring inflation back to target over the medium term. How much and how quickly will depend on future developments and on how the current uncertainty plays out. A stronger króna and global price developments have provided the scope to raise interest rates somewhat more slowly than was previously considered necessary, but they do not change the need for a tighter monetary stance in the near future. In addition, the interest rate path will depend on whether other policy instruments are used to contain demand-side pressures in the coming term. After adjusting for cyclical factors, the expected Treasury outcome for 2015 and the fiscal budget proposal for 2016 entail an easing of fiscal policy, which will call for a tighter monetary stance, other things being equal.
The MPC has decided to increase reserve requirements from 2% to 4% as of the next reserve maintenance period, which begins on 21 October. The purpose of this is to strengthen the Bank’s liquidity management, in the wake of its substantial foreign currency purchases in the recent term and in connection with the winding-up of the failed banks’ estates and the planned auction to release or tie up offshore krónur. New Rules on Reserve Requirements will be sent today for publication in the Law and Ministerial Gazette."
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