Iceland's central bank held interest rates unchanged on lower-than-expected inflation in August and a slow recovery of domestic demand, but added that is is likely to raise rates in the near future.
The Central Bank of Iceland said earlier interest rate increases in May and June, together with lower inflation, had withdrawn some of the accommodative monetary policy, which has helped support the economic recovery.
But as this spare capacity gradually disappears, the monetary policy slack should also disappear, but the degree of future rate rises would depend on how inflation evolves, the bank said.
"But in the absence of changes in the outlook for inflation and the economic recovery, it is likely that further interest rate increases will be needed in the near future," the central bank said.
Last month the International Monetary Fund (IMF) called for tighter monetary policy in Iceland to tackle inflation. Iceland's central bank targets annual inflation of 2.5 percent.
The bank's benchmark seven-day collateralised lending rate was held at 5.75 percent.
The annual inflation rate rose to 4.3 percent in September from 4.1 percent in August while the economy contracted by 6.5 percent in the second quarter from the first quarter for an annual growth rate of 0.5 percent.
"Recent economic indicators suggest a slower recovery of domestic demand than was forecast in August. On the other hand, risks stemming from the financial crisis in Europe have abated," the bank said.
Iceland was hit hard by the global financial crises, with its economy shrinking by more than 10 percent in 2009 and 2010. But in 2011 it expanded by 2.6 percent due to strong exports.
The central bank has already raised rates three times this year, for a total increase of 100 basis points.
At their previous meeting in August, the central bank board discussed a 25 basis points increase.