12 December 2002

Central Bank of Iceland lowers interest rates

The Board of Governors of the Central Bank of Iceland has decided to lower the yield in the Bank's repurchase agreements with credit institutions by 0.5 percentage points, to 5.8 percent, effective at the next auction of repurchase agreements on December 17, 2002.

The decision to lower interest rates is based on the assessment that economic data released since the Central Bank published its latest inflation forecast in early November 2002, has further increased the probability of inflation being below target over a two year horizon. This assumes no change in monetary policy and does not take into account probable large scale foreign direct investment projects in the aluminium sector.

Changes in the CPI in November and December suggest that inflation in the fourth quarter will be below the Central Bank's November inflation forecast. The inflation target was reached in November and headline inflation fell below 2% in December. However, in the Bank's view, headline inflation this year has not fully reflected underlying inflation. Indices of core inflation support that view, having during the last twelve months increased slightly above the Bank's inflation target. On the other hand, appreciation of the króna, by almost 3½% from the level assumed in the inflation forecast of the Bank that was published in early November, will ceteris paribus contribute to lower inflation.

The outlook for domestic demand and output growth is broadly unchanged since the autumn, with some slack emerging in the product and labour market next year. Economic growth in major trading partner countries, on the other hand, has been weaker than anticipated and central bank interest rates have recently been lowered in many of them.

It is likely that after this rate decision  the bank's policy interest rate is in real terms coming close the equilibrium real rate.  Considering a forecast of a very modest slack in the economy, in the absence of large scale investment projects, and taking into account that decisions on these projects might be made within few weeks, the timing and direction of future interest rate changes is currently uncertain. It will as always be determined by economic developments, including the decisions on the mentioned projects.  These potential projects will not be reflected in the interest rate level before a firm decision has been made.

The effects of the current interest rate reduction on the economy will be determined by its transmission to long term interest rates on the bond market and among credit institutions, but these rates have a stronger influence on private consumption and investment  than short term interest rates.

Further information is provided by the chairman of the Board of Governors, Mr. Birgir Ísleifur Gunnarsson, tel. 569 9600

No. 17/2002
December 12, 2002