It is the first rate hike by the Central Bank of Iceland (CBI) since November 2015 and the first change in rates since a 150-basis-point easing cycle from August 2016 concluded with a 25-point cut in October 2017.
Today's rate increase comes after the CBI in June began warning of the need for tighter monetary policy in light of rapid economic growth and wage pressures.
In its October policy statement the bank's monetary policy committee then warned rates would rise if inflation expectations continued to rise and remain above the bank's target of 2.5 percent.
"GDP growth in 2017 and H1/2018 was stronger than previously estimated," CBI said, raising its growth forecast for 2018 to 4.4 percent from an earlier 3.6 percent although growth is expected to slow down and help close the output gap.
For 2019 CBI retained its forecast for economic growth of 2.7 percent, then lowered the 2020 forecast to 2.5 percent from an earlier 3.0 percent, and forecast 2.6 percent growth in 2021.
Iceland's economy has enjoyed an economic boom in recent years, it grew 4.0 percent last year, boosted by a surge in tourism.
Iceland's gross domestic product expanded by an annual 7.2 percent in the second quarter of this year, up from 5.6 percent in the first quarter while inflation rose to 2.8 percent in October from 2.7 percent in September, boosted by higher import prices from a lower exchange rate of the krona and higher oil prices.
"The outlook is for inflation to continue rising and be somewhat above the target next year," CBI said, adding inflation expectations have risen recently and now above target.
In its latest monetary bulletin, CBI maintained its forecast for headline inflation this year to average 2.7 percent, up from 1.8 percent last year, but raised the forecast for 2019 inflation to 3.4 percent from an earlier 2.8 percent as unit labour cost rise 5.3 percent after a 5.6 percent rise in 2018.
In 2020 inflation is seen averaging 2.7 percent and then easing to CBI's 2.5 percent target in 2021.
After rising sharply from March 2015 to June 2017, Iceland's krona has weakened this year and is now 8 percent weaker than CBI projected in its previous forecast from August and at its lowest level in more than two years as export growth has slowed and investors have turned more pessimistic.
The CBI expects the exchange rate to remain broadly at its year-to-date average for the next two years, or a trade-weighted exchange rate index about 3 percent lower in 2018 than in 2017. For 2019 a further 3 percent decline in expected.
Today the krona firmed in response to the rate hike and was trading at 120.4 to the U.S. dollar, down 14 percent 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 raise 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 4.5%.
GDP growth in 2017 and H1/2018 was stronger than previously estimated. Even though growth is expected to slow down in H2, it is forecast at 4.4% for 2018 as a whole, according to the November Monetary Bulletin. This is nearly 1 percentage point more than the Bank forecast in August. GDP growth is projected to ease in the coming term and the positive output gap is expected to close.
Inflation measured 2.8% in October. The difference between measures of inflation including and excluding housing is close to its smallest in over four years. The year-on-year rise in house prices continues to ease, but this is offset by a sizeable increase in import prices in the recent term. This partly reflects the rise in global oil prices, although the króna has also depreciated since August.
The outlook is for inflation to continue rising and be somewhat above the target next year. In addition, inflation expectations have risen recently and are now above target by all measures. The inflation outlook has therefore deteriorated, but on the other hand, the outlook is for growth in economic activity to ease faster than previously expected.
Higher inflation and inflation expectations in recent months have lowered the Central Bank’s real rate more than is desirable in view of current economic developments and prospects. As a result, it is necessary to raise the Bank’s key rate now.
The near-term monetary stance will depend on the interaction between a narrower output gap, wage-setting decisions, and developments in inflation and inflation expectations.
The MPC reiterates that it has both the will and the tools necessary to keep inflation at target over the long term. If inflation expectations continue to rise and remain persistently at a level above the target, it will call for a tighter monetary stance. Other decisions, particularly those relating to the labour market and fiscal policy, will then affect the sacrifice cost in terms of lower employment."
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