The Central Bank of Iceland held its benchmark seven-day collateralised lending rate steady at 6.0 percent and repeated that its accommodative policy stance would have to be tightened as spare capacity in the economy disappears with the degree of normalization hinging on inflation.
The central bank, which has maintained rates this year after raising them by 125 basis points in 2012, said the outlook for inflation had changed little since its May forecast and underlying inflation and expectations had declined but remained above the bank's inflation target.
Iceland's inflation rate was unchanged at 3.3 percent in May and April, above the bank's 2.5 percent target. In May the bank forecast that inflation would hit its target in the first half of 2014.
Iceland's economic growth appears to have been somewhat weaker than the bank forecast in May's monetary bulletin, but the central bank said it was too early to "asset that the growth outlook for the whole year has deteriorated" as output figures are often revised upwards and the most recent indicators suggest that the economic recovery is developing broadly in line with forecasts.
In May the central bank cut its 2013 growth forecast to 1.8 percent from a previous 2.1 percent due to weaker than expected investment. In 2012 the economy expanded by 1.6 percent.
Iceland's Gross Domestic Product was estimated to have expanded by 4.6 percent in the first quarter, up from 0.5 percent in the fourth quarter, for annual growth of 0.8 percent, down from 1.4 percent in the fourth quarter.
In May the central bank had forecast first quarter annual growth of 1.5 percent.
For 2014 the bank has forecast growth of 3.0 percent and for 2015 growth of 3.5 percent.
The exchange rate of the Icelandic krona has been broadly unchanged since the last meeting by the central bank's monetary policy committee in May and the bank said its "intervention policy formula" appears to have contributed to "greater exchange rate stability and is therefore conducive to providing a firmer anchor for inflation expectations and promoting more rapid disinflation that would occur otherwise."
At the May meeting the krona was quoted at 122.9 to the U.S. dollar and today it was quoted higher at 120.5, up 4 percent since the start of the year when it was trading at 128 to the dollar.
In May the central bank said it would take a more active role in the foreign exchange market to reduce fluctuations and the current exchange rate level was sufficient to bring inflation back to target.
Prior to the global financial crises, the krona was roughly twice a strong at around 60 to the U.S. dollar but Iceland's three largest banks collapsed in 2008 and currency controls were imposed in November 2008 to the protect the krona after it plunged in mid-2008.
Iceland's new government plans to unveil by September a plan on how to ease currency and capital controls that is likely to include some restrictions to avoid that $8 billion of funds trapped in the country don't suddenly disappear, leading to another plunge in the krona. Iceland has already asked creditors in the three banks to forgive some $3.6 billion.
Iceland's central bank appealed to the new government to bring its finances into balance as soon as possible so the policy mix can contribute to the country's external balance, economic stability and help bring inflation close to target "at the lowest possible cost."
"It is still the case that as spare capacity disappears from the economy, it is necessary that slack in monetary policy should disappear as well," the central bank said, repeating a phrase that is has used for many months.
It added that the degree to which such normalisation takes place through changes in central bank rates will depend on on inflation, which in turn depends on wages and the exchange rate.