27 March 2002

The Central Bank of Iceland lowers interest rates

The Board of Governors of the Central Bank of Iceland has decided to lower the yield in the Bank's repurchase transactions with credit institutions by 0.5 percentage points effective at the next auction of repurchase contracts on April 2, 2002. The interest rate on the current accounts of credit institutions in the Central Bank will be lowered by 0.5 percentage points on April 1, 2002, but the rate on overnight advances will be unchanged.

As reported in the February issue of the Monetary Bulletin of the Central Bank, the Bank felt at that time that there were no grounds for a decrease in interest rates for the time being. Nevertheless, the underlying assumptions could change fairly quickly. Exchange rate and price developments in the weeks and months to come would be an important factor in that respect. The exchange rate of the króna has now appreciated by 2.3 percent since January 21 when the assumptions underlying the latest inflation forecast of the Bank were fixed. Furthermore, the two most recent measures of the CPI indicate a low underlying rate of inflation so far this year. That development is partly explained by the special effort undertaken to contain price increases. Its long-term impact on inflation is uncertain. In addition, it is possible that the impact of the exchange rate depreciation in 2000 and 2001 may still be felt in the period ahead if the exchange rate of the króna does not appreciate further. However, developments over the last few weeks have overall increased the likelihood that inflation this year will be in line with the inflation forecast of February.

The Economic Indicators of the Central Bank published last week confirm that the labour market is slackening. There are also indications that the credit expansion of deposit banks continues to slow down. In addition, according to the latest information from the National Economic Institute, the positive output gap is likely to disappear this year. These developments were by and large foreseen when the Bank published its most recent inflation forecast according to which the inflation target was not going to be reached in the course of 2003. The appreciation of the króna in recent weeks and the relatively favourable development of prices in the last two months increase the likelihood ceteris paribus that the inflation target will be reached in 2003. The Central Bank will publish a new inflation forecast at the beginning of May.

Despite the 0.5 percentage point reduction in interest rates now, real Central Bank interest rates remain high, particularly in light of the forecast rate of inflation. Thus, considerable monetary restraint continues to be applied. The Bank deems that to be unavoidable for still some time in order to ensure the attainment of the inflation target. As inflation has been considerably above an acceptable level in the recent past, monetary policy must first and foremost aim at reducing it.

In his address to the Annual Meeting of the Central Bank on March 26, 2002, the Chairman of the Board of Governors presented the analysis of the Bank of monetary and economic developments, current conditions and prospects that inter alia formed the background to the interest rate decision of the Board of Governors.


Nr. 3/2002
March 27, 2002