Monetary policy statement of the Board of Governors of the Central Bank of Iceland: Policy interest rate unchanged
The Board of Governors of the Central Bank of Iceland has decided to leave the Bank's policy interest rate unchanged at 13.75%. The inflation forecast in the November issue of Monetary Bulletin assumed an unchanged policy rate through mid-2008. Despite signs of considerable changes ahead in the Icelandic economy, the Board of Governors does not believe there is reason to depart from that forecast at this time. Inflation is still considerably above the Bank's target.
According to economic indicators, demand – private consumption in particular – grew rapidly through the end of 2007. The labour market remains very tight, and contractual wage negotiations are still underway. The króna has depreciated to levels below the path assumed in the November forecast. The short-term inflation outlook is therefore less favourable than it was in November and in December, when the Board of Governors announced its most recent policy rate decision.
On the other hand, financial market conditions have continued to deteriorate, both in Iceland and in the global markets, since the Bank's last policy rate decision. The supply of credit available to households and companies has shrunk, and lending terms have become less favourable. Equity prices have dropped significantly since the beginning of 2008, which raises the cost of capital and weakens the balance sheets of businesses and households alike. Real estate prices are expected to decline. A downturn in housing prices was forecast in November, and it could prove deeper than was predicted then, despite starting later.
These developments support the Central Bank's tight monetary policy, as they contain demand growth and reduce inflationary pressure, as well as having a direct effect on inflation through the housing component of the CPI. It is uncertain how quickly this will happen. However, it is unlikely that a sharper contraction than that predicted by the Central Bank in November will spark more rapid disinflation early in the forecast horizon. The króna could depreciate concurrent with a reduction in the supply of foreign capital. Such a combination of events could raise inflation expectations and cause wage drift, thereby delaying disinflation.
It cannot be asserted at this time that the long-term inflation outlook has changed materially since November. Uncertainty is greater than before, however, especially as regards the impact of deteriorating financial conditions – shrinking credit supply and rising interest premia – on demand and inflation. For the longer term, trends in inflation are determined largely by the interplay between exchange rate developments and the output gap. In the weeks to come, the Central Bank will follow developments in economic indicators very closely, particularly those that reflect the impact of poorer financial market conditions on lending and demand.
As before, controlling inflation and anchoring inflation expectations is vital for the economic well-being and balance sheets of households and businesses. The Board of Governors will continue to base its policy rate decisions on this fundamental consideration.
February 14, 2008