The Board of Governors of the Central Bank of Iceland has decided to raise the policy interest rate in the Bank's repurchase transactions by 0.2 percentage points to 5.5%, effective at the next auction of repurchase contracts on May 11, 2004.

This decision is based on the Bank's most recent macroeconomic and inflation forecasts, which were published in Monetary Bulletin on March 17 this year, and subsequent economic developments. All things being equal, inflation was forecast to exceed the Bank's target in the third quarter of 2005, with the output gap turning from negative to positive in the near future. Against this background, the Bank declared that, all things being equal, the inflation forecast called for a rise in the policy interest rate in the next few months.

Unfolding developments in recent weeks have confirmed important assumptions underlying the forecast. Agreements have been signed on an expansion to the Norðurál aluminium smelter and the latest indicators show ongoing growth in domestic demand as well as a tightening in the labour market. It is likely that inflation will exceed the Bank's target sooner than was assumed in the March forecast, given that long-term interest rates have been falling and that the Consumer Price Index has risen by more than market expectations in the past two months and the króna is currently 3.7% weaker than assumed then. Higher oil prices could drive the CPI above the inflation target in the next few months, although such factors are normally ignored in monetary policy implementation.

In light of the above, the Central Bank now considers there are grounds for launching the process of tightening the monetary policy stance that it has been signalling in recent months. As always, the timing and scope of the next steps will depend on unfolding developments. The Central Bank of Iceland will release new macroeconomic and inflation forecasts, together with an assessment of economic and monetary developments and prospects, in the next issue of Monetary Bulletin, which will be published on June 1.

For further information, contact Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of Iceland, tel. (+354) 569 9600.

No. 9/2004

May 6, 2004