08 February 2007

Policy interest rate unchanged

The Board of Governors of the Central Bank of Iceland has decided to leave the policy interest rate unchanged at 14.25%. Inflation has slowed down and the short-term inflation outlook has improved beyond what was expected in the Central Bank’s most recent forecast. However, inflation is still significantly in excess of target.

Lower inflation, an improved short-term inflation outlook and rises in the policy rate last year imply that the policy rate has risen substantially in real terms. In recent months, policy rate hikes have also been transmitted more rapidly across the yield curve than often before and the effect of higher rates has probably still not been felt in full. The current interest rate may therefore suffice to bring inflation to target within an acceptable period of time.

On the other hand, significant macroeconomic imbalances are still present. Iceland’s large current account deficit implies that the stability of the króna depends upon the willingness of international investors and creditors to fund it. Experience shows that even modest changes in international financial conditions can cause sharp swings in exchange rates. If such changes were to lead to a depreciation of the króna, the inflation outlook would worsen again, especially if this happened while the labour market is still tight. There are few signs yet of easing labour market conditions and wages have risen far in excess of productivity in recent years. The impact of that development may not have been fully transmitted to the price level yet. The Central Bank will respond if the inflation outlook takes a turn for the worse.

The Central Bank will announce the Board of Governors’ next interest rate decision on March 29, coinciding with the publication of the macroeconomic and inflation forecast in Monetary Bulletin. The assessment of the inflation outlook then will ignore the impact that the pending reduction in the VAT rate will have on the CPI, since this will not affect the underlying inflation rate.

No. 2/2007
February 8, 2007