Seðlabanki

Statement of the Central Bank of Iceland Monetary Policy Committee: Continued monetary easing conditional on favourable exchange rate developments

Since early May, market interest rates have fallen significantly. Short-term interest rates have come down by roughly 4 percentage points and longer-term real and nominal rates by 0.5 and 1.5 percentage points, respectively. As a consequence, the yield curve has flattened, prompting investors to shift towards longer-term positions. Furthermore, retail deposit rates have fallen markedly.

In its May 7 statement, the MPC expected further easing of monetary policy conditional on favourable exchange rate developments and progress in fiscal consolidation. Since then the króna has been weak. Although the króna has been supported by a significant trade surplus, it now appears that, due to a deficit on the services account and a significant deterioration in the price of exports, the Q1/2009 surplus was smaller than expected. In addition, the April merchandise trade surplus was relatively small. The Central Bank has intervened to support the króna; nevertheless, net reserves have strengthened somewhat over the last quarter.

While inflationary pressures have been subdued due to weak domestic demand and rising unemployment, significant exchange rate effects are still passed through into the CPI, accounting for most of the 1.1% increase in the CPI in May. An apparently temporary rise in the housing component also contributed to the increase. The year-on-year inflation rate eased from 11.9% in April to 11.6% in May. Given stable exchange rates and continued stability of nominal wages, the disinflation process is expected to continue at broadly the same pace as in the May forecast. Projections indicate that inflation will be close to the 2.5% target by early 2010.

As was stated in May, the MPC considers it appropriate to shift the overall policy stance towards fiscal tightening and monetary easing to the extent allowed by exchange rate stability. The first fiscal policy measures have now been passed by Alþingi. As further measures are implemented, the MPC will assess their impact and their implications for monetary policy decisions. The MPC views a decision on 2009 fiscal measures and a firm commitment on 2010-2012 fiscal consolidation as the cornerstone in re-establishing market credibility and thus allowing further monetary easing.

Finally, it is necessary to take into account the gradual release of capital controls, which is likely to begin late this year. A cautious approach to monetary easing facilitates removal of the capital controls while maintaining the value of the króna. Once balance of payments prospects have been clarified, a medium-term fiscal consolidation plan approved, bilateral and multilateral loan arrangements to supplement foreign reserves concluded, and financial sector restructuring advanced, the first steps can be taken towards easing capital controls by lifting restrictions on new investment. The gradual removal of capital controls will be carried out in a manner conducive to currency stability.

The next MPC announcement is scheduled for Thursday, July 2, 2009.