21 December 2006

The Central Bank of Iceland raises its policy interest rate

The Board of Governors of the Central Bank of Iceland has decided to raise the policy interest rate by 0.25 percentage points to 14.25%. The Governors’ decision should be seen in light of the analysis published in Monetary Bulletin 2006/3 on November 2, which implied that the monetary stance was still not tight enough to attain the inflation target over the next two years. At that time, the Board of Governors decided to postpone raising the policy rate for the time being, given its already very high level and the considerably more favourable inflation outlook than in the middle of this year. An additional interest rate decision date was scheduled for today, when the policy rate would be increased unless available data gave grounds for doing otherwise.

Inflation has slowed down since the November forecast and is currently much lower than had been forecast in the middle of the year. Assuming that the exchange rate of the króna remains relatively stable, the outlook is for somewhat lower inflation over the early part of the forecast period compared with path expected in November. This development is not least the result of the tight monetary stance, which will continue to have the intended effect. Nonetheless, in the Governors’ view the long-term inflation outlook has not improved from the November forecast. Inflation is still significantly above the target and even with a sizeable reduction in the coming months still looks set to remain above target for the next two years, especially when the direct effects of a planned cut in consumption taxes in the first half of 2005 are excluded.

Domestic demand in Q3/2006 appears to have grown in pace with the November forecast. There are indications that private consumption may grow even faster in the current quarter than in Q3. The labour market is very tight and pressures appear to have increased in the beginning of the winter. A record current account deficit was recorded yet again in Q3 and there is little likelihood of a substantial improvement in Q4. Thus the current account deficit for the year appears to heading higher than was forecast in November. The current account deficit and labour market data could imply domestic demand growth in 2006 in excess of measurements so far this year, and thereby that the output gap and inflationary pressures have been underestimated, as pointed out in Monetary Bulletin in November.

The policy interest rate is high in historical terms. However, its transmission across the yield curve has not been as effective as was hoped, dampening its impact. The tight monetary stance has nonetheless contributed to exchange rate stability, in spite of the uncertain outlook and wide current account deficit. Inflation prospects and the monetary stance depend heavily on the króna remaining relatively strong.

By raising the policy rate now, the Central Bank affirms its determination to rein in inflation on a lasting basis. The Central Bank will not ease its stance until it is convinced that the long-term inflation outlook is in line with the inflation target.

The next interest rate decision by the Board of Governors of the Central Bank of Iceland will be published on Thursday, February 8, 2007, as previously announced.


No. 47/2006
December 21, 2006