The Board of Governors of the Central Bank of Iceland has decided to raise the Bank's policy interest rate by 0.5 percentage points to 7.25% as of November 1. This is the fifth policy interest rate increase this year and forms part of the Bank's response to sharp growth in domestic demand and the impact that investments for the aluminium industry in the coming years will have on the inflation outlook and macroeconomy. In all, the Bank's policy rate has been raised by 1.95 percentage points since May this year.
An in-depth analysis of economic developments and prospects was included in the Central Bank's latest quarterly Monetary Bulletin, published on September 17. It described how unfolding developments in the financial markets had been counteracting the Central Bank's measures in recent months. The Central Bank had to respond to this development, given that construction work on power stations and aluminium smelters will surge over the next few months. In part, the policy rate increase announced then aimed to counter the easing of financial conditions that had been brought about by recent events. Since the publication of Monetary Bulletin, strong demand for new borrowing has become evident following changes in lending supply. It is clear that the debt service burden of households may ease substantially, allowing them considerably more disposable funds for consumption or housing investment.
Inflation has been some way above the Bank's 2½% inflation target for some time now. The longer that this situation persists, the greater the risk that inflationary expectations, which have been on the increase over the past year, will become anchored at a higher level. Consequently, the Central Bank's policy interest rate has not gone up in real terms to any extent. The policy rate increase announced now aims to counteract the easing of the monetary stance caused by higher inflation expectations, and the laxer financial conditions created by the banks' entrance into the mortgage market and changes in the state Housing Financing Fund's lending rules.
Further measures are probably necessary to bring inflation back down to target. It is crucial to contain inflation. Suffice it to point out that a rate of inflation some way above the Bank's target could trigger a review of current wage agreements in November 2005 and subsequently make the inflation target more difficult to attain.
Investments in the aluminium industry and related hydropower production are now gaining momentum, which by itself presents an ample economic policy challenge. A tighter fiscal stance would have been desirable in the budget proposal for 2005 and longer-term Treasury programmes. In the absence of a tighter fiscal stance, a strong monetary policy response cannot be avoided. Recent forecasts indicate that if this is not done, the current account deficit over the next two years will be so large as to threaten to undermine the exchange rate in the course of time, with repercussions for price stability and putting a strain on the financial system. Monetary measures can only affect such a scenario if they are applied in good time. In addition, recent changes in the housing market delay the intended effect of policy rate rises. A significantly stronger case can now be argued in favour of raising the policy rate sooner rather later. A timely policy rate hike could mean that interest rates would not need to be raised by as much later in order to contain inflation. Further interest rate rises can therefore be expected in the months to come, unless economic developments diverge significantly from the current outlook.
For further information contact Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of Iceland, tel. (+354) 569-9600.
No. /2004
October 29, 2004