The Central Bank of Iceland raised its benchmark interest rate for the fifth time this year and said inflation should now start to decline to the bank's target but warned this path could be upset by the upcoming wage settlement review.
The central bank's Monetary Policy Committee, which raised the 7-day collateralised lending rate by 25 basis points to 6.0 percent, said the economic outlook was broadly unchanged despite the global headwinds.
"The economic recovery will continue, with growing investment and stable private consumption growth, and the slack in the economy will disappear during the forecast horizon," the bank said.
Interest rate hikes since August and falling inflation has withdrawn a "considerable amount" of the central bank's accommodative monetary policy and the slack in monetary policy should disappear as spare capacity disappears from the economy, depending on the path of inflation.
"The current baseline forecast indicates that the bank's present nominal interest rate is sufficient to bring inflation back to the inflation target during the forecast horizon," the bank said, but added:
"However, this depends, among other things, on whether the outcome of the forthcoming wage settlement review at the beginning of next year is consistent with inflation declining to the target."
Iceland's annual inflation rate eased slightly to 4.2 percent in October from 4.3 percent, but this is still well above the bank's 2.5 percent target and inflation expectations were still above this target though they had fallen somewhat.
Iceland's Gross Domestic Product slumped by 6.5 percent in the second quarter from the first, for a 0.5 percent annual rate, down from 4.2 percent in the first quarter.
The central bank has now raised its key rate by 125 basis points so far this year, with inflation also gradually easing from over 6.0 percent in the first half of the year.
In its latest Monthly Bulletin, the central bank said 2011 output growth was weaker than previously estimated and the recovery in the first half of this year was weaker than stated in the August forecast.
Iceland's output growth last year was previously estimated by Statistics Iceland at 3.1 percent but has now been revised down to 2.6 percent, the bank said.
The bank now estimates growth this year of 2.5 percent, 0.5 percentage points down from August, mainly due to a stronger contraction in public consumption than previously forecast. But output growth is projected to be stronger next year than forecast in August and is expected to average just over 3 percent, in line with average long-term growth.
Iceland's economy, which was hard hit by the global financial crises, is expected to reach its pre-crises peak in the latter half of 2014 and close to that level in August 2015, the end of the bank's forecast horizon.