The Central Bank of Iceland, which raised rates by 125 basis points in 2012, said the economic recovery has lost some of its previous pace, which means the margin of spare capacity in the economy has narrowed further while it's accommodative stance is still supporting economic growth.
But if inflation declines slower than forecast, it will be necessary to reduce the monetary slack sooner than otherwise required, the central bank said.
Inflation rose to 4.8 percent in February from 4.2 percent in January and the highest rate in eight months. The central bank targets inflation of 2.5 percent.
"It is still the case that as spare capacity disappears from the economy, it is necessary that monetary policy slack should disappear as well. The degree to which such normalisation takes place through higher nominal Central Bank rates will depend on future inflation developments, which in turn will depend on exchange rate movements and wage-setting decisions in the near future," it added.Iceland's central bank said the outlook is still for a gradual economic recovery and leading indicators are consistent with that prospect.
Inflation, however, "proved considerably higher in February than previous anticipated," the bank said, while on the other hand the Icelandic krona has appreciated.
The bank's decision in February to suspend regular foreign currency purchases and support the krona through foreign exchange intervention has proven effective.
"The Bank’s actions have reduced the risk that self-fulfilling expectations of a depreciation will weaken the króna still further, and in this way they have supported monetary policy," the bank said.
Iceland's Gross Domestic Product expanded by only 0.5 percent in the fourth quarter from the third, down from the third quarter's expansion of 4.8 percent from the second. Annual growth in the fourth quarter was 1.4 percent down from 2.2 percent.