Iceland cuts rate 25 bps to counter rise in krona’s FX rate

December 14, 2016

By CentralBankNews.info
    Iceland’s central bank cut its benchmark interest rate on 7-day deposits by 25 basis points to 5.0 percent to counter a tightening of its monetary stance by the continued rise of the krona’s exchange rate but struck a neutral bias by saying future policy decisions “will be determined by economic developments and actions taken in other policy spheres.”
    The Central Bank of Iceland (CBI) has now cut its rate by 75 basis points this year following a 50-point cut in August.
     Although inflation has remained below the central bank’s 2.50 percent target for nearly three years despite large pay rises and strong demand, the CBI said inflation expectations were more firmly anchored to its target than before, giving it scope to lower nominal rates.
   “Nevertheless, strong demand growth and the aforementioned uncertainties call for caution in interest rate setting,” the CBI said, adding today’s rate cut reflected the bank’s latest forecast and “more recent information.”
   Iceland’s inflation rate rose to 2.1 percent in November from 1.8 percent in October but has been held back by low global inflation and demand, the strong krona and the bank’s tight policy stance.
    Last month the CBI forecast 2016 inflation of 1.7 percent, rising to 2.3 percent in 2017 and 2.6 percent in 2018.
     Attracted by its relatively high interest rates, Iceland’s krona has been firming since March 2015 and was trading at 112.7 to the U.S. dollar today, slightly down on the day but up 15.2 percent since the start of this year.
    Since the November meeting by the central bank’s monetary policy committee, the krona’s exchange rate has risen 1.5 percent and is already above the CBI’s projected average for 2017.
    The recent composition of economic activity in Iceland is also more favorable than the CBI had forecast in November, with exports and business investment better than expected. As before, the central bank said there was considerable uncertainty about the fiscal policy and there is unrest in the labour market and uncertainty about the impact of the capital account liberalisation.
    Iceland recently dismantled capital controls that were put in place after the global financial crises in 2008 that led to the collapse of its banking system and a halving of the value of the Icelandic krona.
    Last month the central bank said the process of unwinding these capital controls had been smooth and it had been buying less foreign currency than earlier in the year.
    The central bank’s foreign exchange reserves have risen strongly in recent years as it has been buying up foreign currency inflows to build up its war chest and help prevent any possible volatility in the krona’s exchange rate in response to the removal of capital controls.
    Iceland’s Gross Domestic Product grew by 4.7 percent in the third quarter from the second quarter, which grew 1.7 percent, for the strongest rise since the first quarter of 2004. On an annual basis, GDP was up 10.2 percent compared with 3.8 percent in the second quarter. 
    Last month the CBI raised its outlook for 2016 growth to 5.0 percent from a previous forecast of 4.9 percent and 2015’s 4.2 percent. For 2017 GDP was seen expanding by 4.5 percent, up from the August forecast of 4.1 percent, and 2018 growth is seen at 2.9 percent, up from 2.6 percent. Growth in 2019 is seen at 2.7 percent.

    The Central Bank of Iceland issued the following statement:

“The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to lower the Bank’s interest rates by 0.25 percentage points. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore be 5%.
The national accounts for the first nine months of the year show stronger GDP growth than the Central Bank forecast in November. Growth in domestic demand was broadly in line with that forecast, but its composition was different: business investment growth was stronger than projected, while private consumption growth was weaker. Export growth was also stronger than had been forecast, mainly due to robust services exports. The current account balance showed a record surplus in the third quarter of the year.
Inflation measured 2.1% in November and has remained below target for nearly three years despite large pay increases and rapid demand growth. This is due largely to favourable external conditions and the appreciation of the króna but also to a tight monetary stance, which has anchored inflation expectations.
The MPC’s decision to lower interest rates reflects the Central Bank’s last forecast and more recent information. The exchange rate has risen by 1½% since the Committee’s last meeting and is already above the projected average for 2017. In addition, the composition of GDP growth is more favourable than was forecast in November, in that exports and business investment weigh more heavily than previously projected. Both of these factors affect the Committee’s risk assessment. As before, there is considerable uncertainty about the fiscal stance, which has eased in the past two years and still remains uncertain because it is unclear at present what the next Government’s economic policy will be. As in November, there is unrest in the labour market and uncertainty about the impact of upcoming steps towards capital account liberalisation.
Inflation expectations appear more firmly anchored to the target than before, and the monetary stance has tightened to some extent, through the appreciation of the króna. This gives the MPC some scope to lower nominal interest rates now. Nevertheless, strong demand growth and the aforementioned uncertainties call for caution in interest rate setting. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres.”

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