However, the Central Bank of Iceland (CBI) also said that "global price developments and a stronger krona have provided scope to raise interest rates more slowly than was previously considered necessary" and there were signs that inflation expectations had been anchored more securely than before, contributing to a more moderate rise in inflation than would have been expected given large pay increases.
Last year the CBI raised its policy rate by 125 basis points to curb inflationary pressure but in its latest monetary bulletin, the central bank lowered its forecast for inflation this year to 2.1 percent from February's forecast of 2.3 percent while the forecast for 2017 inflation was unchanged at 4.1 percent and the 2018 forecast was raised to 3.8 percent from 3.4 percent as economic growth is now seen to be higher than earlier forecast.
"How much and how quickly the monetary stance must be tightened will depend on future developments," said the CBI, which targets inflation of 2.5 percent.
Despite large pay rises and a positive output gap, Iceland's inflation rate has been below the bank's target for over two years and in April it rose to 1.6 percent from 1.5 percent in March as domestic inflationary pressure was offset by the strong exchange rate of the krona and "usually" low global inflation.
The central bank revised upwards its forecast for economic growth to 4.5 percent this year from 4.2 percent following growth of 4.0 percent last year.
Gross Domestic Product in 2017 is seen expanding by 4.0 percent, up from 3.4 percent previously forecast, and by 3.0 percent in 2018, up from 2.9 percent as domestic demand as the unemployment rate falls to 3.3 percent this year, 3.2 percent in 2017 and 3.4 percent in 2018.
After losing about half its value during the global financial crises, Iceland's krona has appreciated steadily since March 2015 and rose further today, trading at 122.7 to the U.S. dollar, up 5.8 percent since the beginning of this year.
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 5.75%.
According to Statistics Iceland estimates, GDP growth measured 4% in 2015, well in line with the Central Bank’s February forecast. The outlook is for even stronger GDP growth this year, or 4.5%, according to the forecast published in Monetary Bulletin today. This is slightly more than was forecast in February. The outlook for 2017 has also been revised upwards, with GDP growth now projected at 4% instead of the 3.4% forecast in February. In the domestic labour market, growth can be seen in rapid job creation, a rising participation rate, and declining unemployment. Long-term unemployment has nearly disappeared, and firms are having more difficulty filling available positions than they have for quite a long time.
In spite of large pay increases and a widening positive output gap, inflation has remained below target for over two years. In April, inflation measured 1.6%, about the same as a year ago. As before, this reflects the offsetting effects of domestic inflationary pressures versus the appreciation of the króna and unusually low global inflation. Other things being equal, the outlook is for inflation to remain below target well into this year but then rise when import prices stop falling. According to the Central Bank forecast, inflation will measure 3% in Q4/2016 and 4½% in the second half of 2017, but then begin to ease back to target in response to monetary tightening. This is somewhat higher inflation than was forecast in February, as the outlook is now for stronger growth in economic activity than was assumed then.
Global price developments and a stronger króna have provided the scope to raise interest rates more slowly than was previously considered necessary. By the same token, there are signs that monetary policy has anchored inflation expectations more securely than before and contributed to a more moderate rise in inflation than could have been expected in the wake of large pay increases. However, this does not change the fact that, according to the Bank’s forecast, a tighter monetary stance will probably be needed in the coming term, in view of growing domestic inflationary pressures. How much and how quickly the monetary stance must be tightened will depend on future developments."
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