The Board of Governors of the Central Bank of Iceland has decided to raise the policy interest rate of the Bank by 0.5 percentage points, to 6.25%, from the next auction of repurchase contracts on July 6, 2004. In the introductory chapter of Monetary Bulletin 2004/2, which was published on June 1, 2004, it was stated that the economic outlook could warrant a larger increase in interest rates than the 0.25 percentage point increase announced at that time. Consequently, in the absence of a strong evidence of more favourable inflation outlook, another hike could be expected soon.

Economic developments in June do not give grounds to deviate from previous intentions to tighten monetary policy further. Inflation increased to 3.9% in June, approaching the upper tolerance limit, and may surpass the limit in the next few months.  According to the forecast published on June 1, inflation was expected to rise slightly above the tolerance limit in the following quarters but subsequently abate towards the target next year. Including today's action, the Central Bank has raised interest rates three times, altogether by 0.95 percentage points, since early May.

Although the current inflation is partly of external origin, beyond the control of the Central Bank, domestic price increases have also contributed to higher inflation. The rise in housing costs has been particularly pronounced. Most indicators suggest strong growth of domestic demand. First quarter private consumption rose e.g. by 8% year-on-year and there is strong evidence of continued firm growth in the second quarter.

Data which has been published since the Bank raised its policy rate on June 1 has strengthened the case for further increases. This includes information on inflation, private consumption, investment, and rising inflation expectations which have lowered the real policy rate. Hence it was decided to raise the policy rate by 0.5 percentage points at this time. The large investment projects on the horizon will ceteris paribus require further increases in coming months. The pace of interest rate increases will depend on a number of factors, not least inflation developments and domestic demand growth. In the coming months the Central Bank will monitor economic developments closely and adjust monetary policy with a view of the objective of maintaining the rate of inflation close to 2½%.

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

No.19/2004

July 1, 2004

[1] A joint declaration of the Central Bank and the government on an inflation target and a new framework of monetary policy from June 27, March 2001 states that in the event inflation deviates from target beyond the tolerance limits the Central Bank should make an effort to bring inflation within the limits as soon as possible. The Central Bank is furthermore required to write a report to the government to explain the cause of the deviation, how the Bank intends to respond and when it expects to reach the inflation target again. The report shall be published. <'xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />