Statement of the Central Bank of Iceland Monetary Policy Committee : Careful easing of monetary policy continues

The Monetary Policy Committee (MPC) has voted to lower the policy rate by 1.5 percentage points to 15.5%. After its meeting in March, the MPC concluded that the conditions for monetary easing were in place. Economic developments since March 19 have been broadly consistent with this view.

As before, monetary policy is guided by the interim objective of stabilising the exchange rate, while the long-term goal remains the inflation target. This is primarily because of the need to protect vulnerable private sector balance sheets during the restructuring phase.

The króna has depreciated by nearly 9% since March 19. The weakness of the króna appears to have been driven by transitory factors, such as relatively large seasonal interest payments on non-resident ISK holdings. While the trade account has moved into surplus, there remains considerable uncertainty concerning the overall current account. Moreover, there is evidence that the capital controls were being circumvented. The authorities have now addressed this problem by closing loopholes in the legislation.

The MPC does not consider it likely that its March 19 decision to lower the policy rate by one percentage point had a significant impact on the króna. The wide interest rate differential between the króna and the major currencies should continue to provide scope for continued careful easing of monetary restraint without jeopardising the stability of the króna. Since end-2008, the spread between the domestic policy rate and the ECB policy rate has increased slightly.

Inflationary pressures have continued to subside. The CPI fell by 0.6%  in March, bringing the rate of inflation down from 18.6% in January to 15.2%. The decline in inflation was associated with a sharp contraction in domestic demand, as well as favourable exchange rate developments. Housing demand has been particularly weak, leading to a significant drop in the housing component of the CPI. Short-term indicators of domestic demand, such as turnover data, suggest that the contraction has continued in Q1/2009. Business confidence has recovered slightly from an all-time low. The labour market has also continued to soften, with unemployment registrations rising at a rapid rate and wage pressures remaining subdued. In the MPC's view, recent developments indicate that inflation will continue to fall rapidly, broadly in line with the Central Bank's January forecast. Businesses' inflation expectations have also declined sharply.
The appreciation of the króna in January and February contributed to the benign inflation outcome. The weakness of the króna in March is unlikely to slow down the disinflation process materially, given the sharp contraction of domestic demand. In view of long-term fundamentals, the króna also appears likely to recover from its recent position. Such a recovery is consistent with the view of the MPC during its deliberations in March.
Because they prevent disorderly capital outflows, capital controls are an unfortunate but indispensable element of a strategy aimed at protecting balance sheets and promoting a sustainable recovery. In its March 19 statement, the MPC concluded that, due to remaining uncertainties, the conditions for lifting the capital controls were not yet in place. Increased clarity about balance of payments prospects, the medium-term fiscal consolidation plan, and progress in financial sector restructuring are the prerequisites for a significant easing of controls. While current domestic and external circumstances do not yet allow for the removal of the capital controls without the risk of instability, the Central Bank of Iceland regularly assesses their effectiveness and is exploring possibilities for their gradual, systematic easing as soon as conditions permit.

The next MPC announcement is scheduled for May 7, 2009.

No. 13/2009
April 8, 2009