02 July 2009

Statement of the Central Bank of Iceland Monetary Policy Committee: Further monetary easing requires a stronger króna

The Monetary Policy Committee (MPC) has voted to keep the policy rate unchanged at 12% and the deposit rate at 9.5%. The decision was motivated by the króna remaining significantly weaker than the level the MPC referred to as acceptable in its March minutes. Inflation and inflation expectations have also risen. Money market liquidity has increased in recent months and market rates have fallen below the policy rate.

The MPC is concerned about maintaining the stability of the króna, both while capital controls are in place and at the time that they are removed. While capital controls are in place, trade flows are a factor in determining the value of the currency. Despite structural improvements in the trade account, a deterioration of the terms of trade and large seasonal interest payments to non-residents have had a negative impact on the current account. Therefore, it becomes even more important to provide sufficient incentive to hold króna assets, bolstering the case against a further interest rate decrease.

The substantial depreciation of the króna since March, along with recent increases in excise taxes, were the main reasons for a 1.4% increase in the CPI in June, bringing the twelve-month inflation rate up to 12.2% from 11.6% in May. Excluding the impact of excise tax hikes, the CPI rose by 1% in June, and by 11.5% year-on-year.

Annualised seasonally adjusted three-month inflation has also increased substantially, measuring 9.5%, or 6.3% adjusted for the increase in indirect taxes, after falling to near zero recently. Inflation in Q2/2009 therefore proved somewhat higher than in the baseline forecast in the May Monetary Bulletin. Second-round effects are expected to be limited, however, due to the unusually weak labour and product markets. A stability pact recently concluded by the social partners extends key wage agreements until 2010, thus further reducing the risk of wage inflation.
Since the last MPC meeting, significant progress has been made on several fronts. First, with the adoption of a medium-term fiscal plan, an important step has been taken towards fiscal consolidation. This should gradually increase the scope for monetary easing, both because it enhances confidence in the sustainability of government finances, making domestic sovereign debt a more attractive asset, even at interest rates lower than the prevailing ones, and because it contributes to a larger trade surplus by reducing domestic demand. Second, financial sector restructuring is proceeding, and the largest banks are to be recapitalised in mid-July. Bank and corporate sector restructuring will also be facilitated by new legislation on the asset management company and the state banking agency. Finally, bilateral loan agreements have now been reached with the other Nordic countries, and the IMF programme is advancing.
The public and external debt situation is close to being clarified, which will likely contribute to reducing risk premia. This will support a gradual removal of capital controls in a manner consistent with a stable króna, starting with a release of new investments. During this phase, the MPC will exercise vigilance concerning the impact of its actions on the exchange rate and inflation. This could imply raising interest rates if conditions warrant it.

The next MPC announcement is scheduled for Thursday, August 13, 2009.

No. 22/2009
July 2, 2009