18.05.2006

The Central Bank of Iceland raises interest rates

The Board of Governors of the Central Bank of Iceland has decided to raise the Bank’s policy interest rate by 0.75 percentage points to 12.25%. The Board’s decision is motivated by a considerable deterioration in the short term as well as the medium-term inflation outlook on the assumption of unchanged policy rate. In the introductory chapter of Monetary Bulletin 2006/1, which was published on March 30, it was stated that the Central Bank might have to raise its policy rate considerably in addition to the 0.75 percentage point increase decided on at that time in view of the inflation outlook. Since inflation projections underlying that decision were prepared the króna has depreciated substantially, inflation risen and the medium-term inflation outlook deteriorated commensurably. Large current account deficit in the first quarter of 2006 indicates a risk of further downward pressure on the króna in the months ahead. In order to moderate its effects on domestic inflation it is essential to maintain a very restrictive monetary policy stance over an extended period ahead.

Most indicators point towards an ongoing rapid growth of domestic demand so far this year. Imports of consumer goods and turnover data indicate a continued rapid growth of private consumption. Still there is no sign of a slow down in domestic credit growth. Despite anecdotal news of a slow down in turnover and sporadic evidence of the lowering of prices, indicators of an imminent cooling of the housing market remain inconclusive. Unemployment continues on a downward trend and employment expanded in the first quarter at its fastest rate since labour market surveys started. The combination of an increasingly tight labour market and deteriorating inflation outlook enhance the risk of excessive wage growth.

Economic developments since the end of March indicate that a considerable increase in the policy rate may be required to maintain sufficiently tight monetary conditions. Rising inflation expectations have caused the real policy rate to decline. Furthermore, the depreciation of the króna has eased conditions in the traded goods sector. The current policy rate hike is intended to respond to these developments. Attaining the inflation target within an acceptable period of time is the firm intention of the Central Bank.

 

No. 19/2006
May 17, 2006

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