It is the first rate cut by the Central Bank of Iceland (CBI) this year and follows two rate cuts in 2016 by a total of 75 basis points. The CBI has cut its rate by a total of 100 points since August 2016.
Today's rate cut comes against a backdrop of stronger-than-expected economic growth, continued appreciation of the Icelandic krona and an improved outlook for inflation in the short term.
In an update to its quarterly forecast, the central bank lowered its outlook for headline inflation this year to 1.7 percent from February's forecast of 1.9 percent, the 2018 forecast to 2.2 percent from 2.5 percent but then raised its to 3.3 percent in 2019 from a previous 2.8 percent.
"Two opposing forces affect the inflation outlook," the CBI said. "Demand pressures in the economy have turned out stronger than previously forecast but they are offset by the higher exchange rate."
Iceland's inflation rate rose to 1.9 percent in April from 1.6 percent in March, below the central bank's 2.50 percent target.
Buoyed by a rise in tourism and the prospect of more fiscal easing, the CBI's outlook for economic growth was raised to 6.3 percent for this year, up from 5.3 percent previously forecast.
For 2018 the central bank expects growth of 3.5 percent, up from 3.1 percent, and for 2019 2.5 percent, up from 2.6 percent. The 2016 estimate was raised to 7.2 percent from 6.0 percent.
With booming domestic demand and home prices, a welcome rise in the krona's exchange rate has helped dampen some of the inflationary pressures, the central bank said.
"The currency appreciation and low global inflation continue to offset domestic inflationary pressures, and the gap between domestic price developments - housing costs in particular - and external factors has widened even further since the MPC's last meeting," the CBI said.
The krona has been appreciating steadily since March 2015 and was trading at 101.9 to the U.S. dollar today, up around 11 percent this year. It eased slightly following the CBI's rate cut.
The CBI recently scaled down its interventions in the foreign exchange market to only ease volatility due to strong stock of foreign reserves and said the "appreciation of the krona is considered to reflect economic fundamentals."
There is growing concern in Iceland over the sharp rise in the krona and economic overheating while the country has only just dismantled the bulk of its capital controls that were put in place in the wake of the 2008 global financial crises to protect the currency from total collapse.
The financial crises led to the closure of the country's three largest banks and a committee of experts is currently considering a radical overhaul of Iceland's monetary policy, including pegging the krona to a major currency, most likely the euro.
The Central Bank of Iceland issued the following statement:
"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to lower the Bank’s interest rates by 0.25 percentage points. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore be 4.75%.
The outlook is for strong GDP growth this year, as in 2016, with growth for both years exceeding the February forecast. The deviation from the forecast stems mainly from stronger-than-expected growth in tourism, while there is also the prospect of more fiscal easing in 2017 than was previously projected. Demand pressures in the labour market and the general economy have therefore grown despite increased importation of labour and strong productivity growth. This is offset by the appreciation of the króna. The króna has played a key role in the economy’s adjustment to positive shocks deriving from improved terms of trade and growth in the tourism sector.
Inflation measured 1.9% in April, broadly similar to the level in the past six months. Underlying inflation appears to have declined in recent months, however. The currency appreciation and low global inflation continue to offset domestic inflationary pressures, and the gap between domestic price developments – housing costs in particular – and external factors has widened even further since the MPC’s last meeting. Two opposing forces affect the inflation outlook. Demand pressures in the economy have turned out stronger than previously forecast, but they are offset by the higher exchange rate. The inflation outlook has improved for 2017 and 2018 but has deteriorated further out the forecast horizon.
Clear signs of increased demand pressures in the economy call for a tight monetary stance so as to ensure medium-term price stability. The Central Bank’s real rate has risen slightly since the MPC’s last meeting. The appreciation of the króna also contains demand.
The Central Bank has scaled down its intervention in the foreign exchange market in view of its strong foreign exchange reserves, as the appreciation of the króna is considered to reflect economic fundamentals. As before, the Bank will intervene in the market in order to mitigate volatility when it considers such intervention warranted.
A stronger anchor for inflation expectations at target and the appreciation of the króna have enabled the MPC to achieve its legally mandated price stability objective with a lower interest rate than would otherwise have been possible. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres."
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