The Central Bank of Iceland (CBI), which cut its rate by 50 basis points in August for the first change in rates since November 2015, also said it continued to be cautious in setting interest rates given the uncertainty associated with the liberalization of the country's capital account and the likelihood of increased macroeconomic imbalances.
Iceland is in the final stage of dismantling remnants of capital controls that were put in place following the global financial crises in 2008 that led to the collapse of its banking system and a halving of the value of the Icelandic krona.
But since March 2015 Iceland's krona has been steadily firming and was trading at 114 to the U.S. dollar today, up almost 14 percent since the start of the year.
Iceland's economy looks to be growing even more than the CBI had expected while inflation remains below its 2.50 percent target despite large pay rises and strong demand as the krona's appreciation, despite "large" foreign currency purchases by the CBI, have offset the impact of higher wages on inflation.
Iceland's inflation rate rose to 1.8 percent in September from 0.9 percent in August but this was partly due to a correction by the statistics office of errors from March through August.
Although the central bank's inflation outlook is unlikely to have changed from its forecast in August, its estimate was less than previously thought.
In August the central bank lowered the forecast for consumer price inflation, excluding the effect of indirect taxes, this year to an average of 1.7 percent from 2.1 percent forecast in the May bulletin.
For 2017 inflation, inflation is now seen at 3.2 percent, down from 4.1 percent and for 2018 at 3.6 percent from 3.8 percent.
The CBI forecast that economic output would rise by 4.9 percent this year, up from 4.0 percent in 2015 as private consumption rises by 6.7 percent.
For 2017 the central bank forecasts economic growth of 4.1 percent and 2.6 percent in 2018.
Iceland's Gross Domestic Product grew by an annual 3.7 percent in the second quarter of this year, down from 4.4 percent in the first quarter.
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 5.25%.
As before, GDP growth is expected to be robust both this year and in 2017. The most recent indicators suggest even stronger growth than previously expected. In spite of large pay increases and rapid demand growth, inflation has remained below target for two-and-a-half years. Improved terms of trade, low global inflation, tight monetary policy, and the appreciation of the króna in spite of large foreign currency purchases by the Central Bank have offset the effects of wage increases on inflation.
In September, inflation rose significantly between months, to 1.8%. In part, this reflects the correction by Statistics Iceland of an error in its inflation measurements for the period from March through August. The Central Bank’s overprediction of inflation earlier in the year was therefore less than previously thought. However, the inflation outlook is unlikely to have changed from the forecast published by the Bank in August, as the króna has appreciated still further and inflation expectations remain close to target.
The likelihood of increased macroeconomic imbalances and the uncertainty associated with capital account liberalisation argue for caution in interest rate setting. The monetary stance in the coming term will therefore depend on economic developments and the success of the capital account liberalisation process."
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