Policy announcement by the Board of Governors of the Central Bank of Iceland:

Policy interest rate unchanged

The Board of Governors of the Central Bank of Iceland has decided to leave the Bank’s policy interest rate unchanged at 13.75%. The inflation forecast that was published in the November issue of Monetary Bulletin envisaged an unchanged policy rate until mid-2008. Inflation has been higher than expected in the last two months and is now higher than is consistent with the Bank´s inflation forecast from November. Aggregate demand growth in the third quarter was stronger than forecast, and indicators imply that the strong momentum will be sustained in the fourth quarter. The near-term inflation outlook is therefore less favourable than it was when the last policy rate decision was made, but the long-term inflation outlook has not changed materially.

Conditions on global financial markets have continued to deteriorate. As a result, and because of the high policy rate, domestic interest rates have risen sharply since the Central Bank´s last policy rate decision, while the supply of credit has diminished. Interest rates on long-term indexed bonds, which earlier were slow to respond to tightened monetary policy, have risen sharply this year, especially since the policy rate hike in November. Equity prices have also dropped substantially in the past few months, raising the financing cost of businesses and weakening their balance sheets as well as those of households. These developments are likely to lead to lower real estate prices in the time ahead, as has occurred in many countries, affecting inflation directly, through the housing component of the CPI, and indirectly, through dampened domestic demand.

Unfavourable financial conditions and falling asset prices will reduce demand and ease inflationary pressures. This could be offset by a depreciation of the króna, which is still high in an historical context. The continued strength of the króna is dependent on foreign investors’ desire to take advantage of the interest rate differential and thereby fund Iceland´s current account deficit. While the deficit has narrowed faster than previously expected, the underlying imbalance is still sizable.

The assessment of the Board of Governors is that, as yet, the long-term inflation outlook presented in the November issue of Monetary Bulletin has not measurably changed. Offsetting higher short-term inflation and a larger output gap are the sharp impact of the November policy rate increase on other domestic interest rates – particularly rates on indexed loans – and the tightening effect of deteriorating global financial market conditions. These conditions will reduce domestic demand. It is the Board’s assessment that by maintaining the policy interest rate at the current level the inflation target can be attained within the time frame envisaged in the November baseline forecast; that is, around mid-2009.

If wage and exchange rate developments prove less favourable than assumed in November’s baseline forecast, disinflation could be delayed. Contractual wage negotiations are underway, and higher inflation makes that complex process even more difficult. As there are still no unequivocal signs that labour market pressures are abating, it is possible that wage developments will exert more inflationary pressure than was assumed in November. If this happens, or if inflation rises for other reasons, the Board of Governors will respond appropriately.

The next policy interest rate decision by the Board of Governors of the Central Bank will be announced on February 14, 2008.

Nr. 23/2007
December 20, 2007