Statement of the Central Bank of Iceland Monetary Policy Committee: Central Bank lowers interest rates

The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to lower the Bank’s interest rates by one percentage point. The deposit rate (current account rate) will be 5.5%, and the maximum bid rate for 28-day certificates of deposit (CDs) will be 6.75%. The seven-day collateralised lending rate will be 7.0% and the overnight lending rate 8.5%.

Inflation has declined markedly in recent months. Twelve-month inflation fell from 7.5% in May to 4.8% in July, or 4% excluding consumption tax effects. This is more rapid disinflation than in the Central Bank’s May forecast, due in large part to a stronger-than-expected exchange rate. According to the updated inflation forecast, which appears in today’s Monetary Bulletin, inflation excluding tax effects will reach the Bank’s inflation target by year-end and will fall somewhat below target early in 2011. Inflation expectations have also declined sharply in the recent term.

In trade-weighted terms, the króna has appreciated by over 2½% since the MPC’s last meeting, held in June, and by over 2% against the euro, without any foreign exchange market intervention by the Central Bank. Over this same period, the CDS spread on sovereign debt has remained broadly unchanged. The capital controls, developments in terms of trade and the current account balance, and the interest rate differential with major currencies all continue to support the exchange rate.

Lower inflation, lower inflation expectations, a stronger króna, and the prospect of more rapid disinflation than previously expected provide the scope for a larger interest rate reduction than has generally been the case in the past year. Declining inflation and inflation expectations have caused real Central Bank interest rates to rise since the last interest rate decision date. Although recovery appears to be underway, it is still weak at present, and the outlook is for an output slack to remain for the next few years.

Given the inflation outlook, the Central Bank’s interest rates are still rather high, and there are grounds for continuing to lower them; however, it is not yet clear to what extent the recent disinflation episode reflects short-term factors. Moreover, it should be borne in mind that, when capital account liberalisation begins, the risk-weighted interest rate differential between Iceland and abroad must provide sufficient support to the króna. However, there is still some uncertainty about when it will be possible to begin lifting the capital controls. Consequently, it is difficult to state what this entails for interest rate policy over the next few months.

When the Third Review of the Government-IMF economic programme is complete, the preconditions for capital account liberalisation will be in place as regards the foreign exchange reserves and macroeconomic stability. However, there is still considerable uncertainty about the strength of the financial system in the wake of the recent Supreme Court judgments. As a result, it is necessary to review the existing capital account liberalisation strategy in view of changed circumstances and the delays that have already occurred.

As was stated in the last MPC statement, it is important to replace the Central Bank’s borrowed foreign exchange reserves with non-borrowed reserves in the medium term. The appreciation of the króna and the decline in risk premia on Icelandic financial obligations provide now the scope for modest foreign currency purchases for this purpose. Such purchases will begin on 31 August, and the quantity will be decided with the aim of minimising the impact on the króna.

As before, the Committee considers that the premises for continued monetary easing should be in place, provided that the króna remains stable or appreciates and inflation subsides as forecast. The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term.

No. 24/2010
18 August 2010