26 January 2006

The Central Bank of Iceland raises its policy interest rate by 0.25 percentage points

The Board of Governors of the Central Bank of Iceland has decided to raise the Bank’s policy interest rate by 0.25 percentage points, to 10.75%. This is the twelfth policy rate rise since May 2004 and follows hikes amounting to 0.75 percentage points at the end of September and 0.25 percentage points at the beginning of December 2005. In the Introduction to Monetary Bulletin 2005/4, which was published on December 2, it was reported that the hike in September delivered an equivalent change in real terms. As a result, the impact of policy rate rises was finally being transmitted to indexed bond yields. To claim victory in the battle against inflation, however, would be premature. According to the forecast published in Monetary Bulletin in December, inflation will remain some way above the target over the next two years. That forecast was based on an unchanged policy interest rate since before the December hike and a stable exchange rate. A scenario based on a variable exchange rate indicated that a policy rate in line with the average path forecast by financial market analysts might prove inadequate for attaining the target. The long-term outlook for inflationary pressures was also considered negative.

The Central Bank of Iceland has reviewed the inflation outlook in light of unfolding economic developments over the past two months and still considers it unacceptable. In December and January, inflation measured slightly higher than had been forecast in December. For most of this period the króna has also been marginally weaker than forecast. National accounts for Q3/2005 and indicators for the final quarter of the year show that demand growth is still too rapid to be compatible with macroeconomic balance. Pressures in the housing market have also been easing more slowly than hoped. Although the policy rate rises are beginning to impact long-term bond yields, they are still not reflected sufficiently in mortgage interest rates. Growth of credit institution lending – both mortgage lending and other loans – continues to surge. Labour market developments in recent months are also a mounting cause for concern. Clear indications of growing wage drift have emerged over the past three months, as is typically the case when the unemployment rate is as low as at present. Wage costs look set to rise by considerably more next year than is compatible with the inflation target, unless productivity increases much faster than forecast, which must be considered unlikely.

The highest real exchange rate since the 1980s and a record current account deficit indicate sizeable inflationary pressures ahead, even beyond the Central Bank’s forecast horizon. Monetary policy must make a timely response to these conditions, to avoid even tougher measures later. Given the current outlook, the Central Bank may therefore need to raise its policy interest rate further this year.

Other things being equal, the next interest rate decision by the Board of Governors of the Central Bank of Iceland will be announced on Thursday, March 30, coinciding with publication of the next Monetary Bulletin.


No. 4/2006
January 26, 2006