The Central Bank of Iceland (CBI), which cut its rate by 50 basis points in August in the first change in rates since November 2015, added that although inflation expectations were firmly anchored and an appreciation of the krona's exchange rate had tightened monetary conditions, strong growth in domestic demand and a range of uncertainties "call for caution in interest rate setting."
Among these uncertainties are the government's fiscal stance, unrest in the labour market, continued uncertainty about the impact of the liberalization of the capital account, and the global economy.
In its latest monetary bulletin, the CBI lowered its outlook for inflation due to the strong krona.
Inflation, as measured by the consumer price index, is seen averaging 2.3 percent in 2017, down from 3.2 percent forecast in August, and 2.6 percent in 2018, down from 3.6 percent. For 2016 inflation is seen averaging an unchanged 1.7 percent and for 2019 2.9 percent.
Iceland's inflation rate was steady at 1.8 percent in October and September, below the central bank's 2.50 percent target for nearly three years as low global inflation and the rise in the krona have offset large pay increases and rapid growth in demand.
But the CBI said this change in the inflation forecast "does not provide as much scope for monetary policy response as might be expected, as the MPC (the bank's monetary policy committee) had already incorporated a strong probability of further appreciation of the currency into its recent policy decisions."
Iceland's krona has been appreciating since March 2015 and was trading at 113.1 to the U.S. dollar today, up 14.8 percent since the start of the year.
The CBI acknowledged that its tight monetary stance, which has slowed growth in demand and credit and thus inflation, had also had the effect of supporting the krona's value, lowering import prices even further and shifting demand toward imports.
Iceland recently dismantled capital controls that were put in place after 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.
So far the process of unwinding these capital controls "has been smooth," the CBI said, adding that it recently had been buying less foreign currency than earlier in the year and considers it "appropriate to continue in this vein."
The central bank's foreign exchange reserves have risen strongly in recent years as it has been buying up foreign currency inflows to build up its war chest and help prevent any possible volatility in the krona's exchange rate in response to the removal of capital controls.
Iceland's economy has been performing strongly in recent years, with growth in the second quarter of 3.7 percent, down from 4.4 percent in the first quarter.
The central bank raised its outlook for 2016 growth to 5.0 percent from a previous forecast of 4.9 parent and 2015's 4.2 percent. For 2017 Gross Domestic Product is seen expanding by 4.5 percent, up from the August forecast of 4.1 percent, and 2018 growth is seen at 2.9 percent, up from 2.6 percent. Growth in 2019 is seen at 2.7 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 5.25%.
According to the baseline forecast published in the November issue of Monetary Bulletin, GDP growth is expected to be robust in 2016 and 2017 and to exceed the Bank’s August forecast. To a greater degree than before, GDP growth is supported by domestic demand, which grew by nearly 10% in H1/2016. Job creation remains strong, unemployment is declining, and there are clearer signs that rapid demand growth is straining domestic resources, although this is offset somewhat by increased importation of foreign labour.
Inflation measured 1.8% in October and has remained below target for nearly three years despite large pay increases and rapid demand growth. Improved terms of trade, low global inflation, and the appreciation of the króna have offset the effects of wage increases on inflation. A tight monetary stance has also played an important role in containing inflation and anchoring inflation expectations. It has done this by slowing demand growth, directing some of the steep rise in income and wealth towards saving, and containing credit growth. In this way, monetary policy has supported the exchange rate of the króna, which has lowered import prices even further and shifted some of the demand towards imports.
According to the Bank’s new inflation forecast, the outlook is for inflation to be below target until mid-2017 and then hover in the 2½-3% range for the remainder of the forecast horizon. This is a significant change from the Bank’s previous forecast, owing mainly to the fact that the baseline forecast is now based on an endogenous exchange rate path and not on the technical assumption that the exchange rate will be constant throughout the forecast period. The inflation outlook has also improved, however, particularly in the short run. The change in the Bank’s inflation forecast does not provide as much scope for monetary policy response as might be expected, as the MPC had already incorporated a strong probability of further appreciation of the currency into its recent policy decisions.
In recent months, the Central Bank has purchased a smaller share of foreign currency inflows than it did earlier in the year. The MPC is of the view that, other things being equal, it is appropriate to continue in this vein.
The MPC’s decision to keep interest rates unchanged is taken upon consideration of the Bank’s current forecast and the Committee’s risk assessment. This includes, in particular, the uncertainty about the fiscal stance, which has eased in the past two years and remains uncertain because it is unclear at present what the next Government’s economic policy will be. In addition, there is unrest in the labour market, not least in the wake of the recent ruling providing for pay increases for elected officials. Moreover, there is continued uncertainty about the impact of capital account liberalisation, although the process has been smooth thus far. Added to this is uncertainty about the global economic outlook.
Although inflation expectations appear to be more firmly anchored to target and the monetary stance has tightened to some extent through the appreciation of the króna, strong demand growth and the aforementioned uncertainties call for caution in interest rate setting. The monetary stance in the coming term will depend on economic developments and actions taken in other policy spheres."
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