The Board of Governors of the Central Bank of Iceland has decided to leave the Bank's policy interest rate unchanged at 13.3%. The inflation forecast published in Monetary Bulletin in July this year implied that a reduction in the policy rate would not be possible until the first half of 2008. In the view of the Board of Governors, there are no grounds for departing from that assessment at present. The exchange rate of the króna has been volatile recently and the short-term inflation outlook has deteriorated somewhat since the last interest rate decision was announced. Long-term prospects are unchanged, however. Exchange rate developments are highly uncertain at present and will largely be determined by developments in global financial markets. Recent movements in the exchange rate of the króna have closely tracked those of other high-yield currencies such as the Australian and New Zealand dollars.

As the Central Bank had forecast in July, inflation has slowed down. The most recent CPI release showed a twelve-month rise of 3.4%, while underlying inflation is estimated close to 6%. Inflation in Q3/2007 is likely to be in line with the forecast, but it may be rather higher in the final quarter, reflecting the slightly weaker exchange rate than initially assumed. Since the strengthening of the króna earlier in 2007 was not fully transmitted in the form of lower goods prices, a more modest price impact may be expected from the recent depreciation than would otherwise be the case.

Indicators suggest that domestic demand is still robust. The labour market remains tight, turnover and housing demand are buoyant and the pace of lending growth has accelerated.

On the other hand, turbulence in the financial markets has led to generally tighter credit terms for financial companies, which is reflected in their lending rates. Financial market unease is also likely to dampen the unrealistically upbeat sentiment that has driven demand in the recent term. Both these factors support the Central Bank's monetary restraint. Furthermore, fishing quotas have been cut by rather more than was assumed in the Central Bank's July forecast, but the full impact will not be felt until some way into 2008.

The analysis of the long-term inflation outlook published in Monetary Bulletin in July still broadly holds. It included an assessment of the inflationary risk posed by a conceivable depreciation of the króna as a result of downturn in global financial market conditions. Recent uncertainties still prevail and it would be imprudent to assume that the episode of unusual volatility is over. Unfolding economic events in the coming months will be partly shaped by this climate.

A tight monetary stance, especially the high policy rate, has brought about a gradual reduction in the inflation rate. However, inefficiencies in the monetary policy pass-through have produced a slower disinflation process than would otherwise be the case. Mortgage interest rates, for example, increased by less and at a slower pace than would have been desirable, contributing to an ongoing rise in house prices.

The Board of Governors of the Central Bank remains committed to attaining the inflation target within an acceptable timeframe. The Board’s current decision reflects the projection made in the July inflation forecast, whereby inflation would move close to target after the middle of 2008. If the inflation outlook takes a turn for the worse, the Board of Governors will respond accordingly. The same applies if prospects improve from the forecast.

The next interest rate decision by the Board of Governors of the Central Bank of Iceland will be announced on November 1, 2007, coinciding with the publication of Monetary Bulletin.

No. 17/2007
September 6, 2007