Iceland's central bank maintained its benchmark seven-day collateralised lending rate at 6.0 percent and repeated that its accommodative monetary policy stance should disappear as spare capacity disappears from the economy with the degree of normalization depending on inflation, which in turn depends on wage developments and exchange rate movements.
The Central Bank of Iceland, which has held rates steady this year after raising them by 125 basis points last year, said its latest monetary bulletin forecast economic growth of 1.9 percent this year, slightly higher than 1.8 percent forecast in May, while growth in 2014 is forecast at 2.8 percent, down from a previous forecast of 3.0 percent, and 2015 growth of 2.9 percent, down from 3.5 percent.
The lower-than-expected output growth in the next two years was mainly due to less investment in the energy-intensive sector, the central bank said, though the recovery of the labour market has been more robust than forecast in May.
Inflation in Iceland is expected to rise slightly in the second half of the year and then start easing towards the central bank's 2.5 percent target early in 2014.
"If wage increases are consistent with the inflation target, inflation will fall more quickly and interest rates will be lower than would otherwise be necessary, other things being equal," the bank said.
Iceland's inflation rate rose to 3.8 percent in July from 3.3 percent in each of the previous three months. The bulletin forecast average inflation of 3.9 percent this year, up from May's forecast of 3.8 percent, 3.1 percent next year and 2.9 percent in 2015.
Year-on-year the headline inflation rate is forecast at 4.0 percent in the third quarter of this year, up from 3.3 percent in the second quarter, and 4.1 percent in the fourth quarter before easing to 3.4 percent in the first quarter of 2014 and then 3.1 percent in the second quarter and then slowly declining.
The Icelandic unemployment rate is forecast at 4.8 percent this year, 4.4 percent in 2014 and 4.3 percent in 2015.
Iceland's Gross Domestic Product rose by 4.6 percent in the first quarter for annual growth of 0.8 percent, down from 1.4 percent in the fourth quarter.
According to forward interest rates, financial markets expect the central bank to keep rates steady this year and then raise them gradually in the first half of 2014.
Since the May bulletin, the Icelandic krona has appreciated by 0.9 percent in trade-weighted terms, the bak said, and by 2.9 percent against the U.S. dollar but depreciated by 0.7 percent against the euro. Today the krona was quoted at 119.8 to the U.S. dollar compared with 128 on January 1, 2013.
During the summer months, the central bank has also bought foreign currency, in line with the foreign exchange intervention strategy announced in May.
"As yet, however, this development has not led to lower inflation expectations," the bank said.
The central bank said there was some uncertainty about the path of public finances in coming years but it expects this to diminish with the presentation of the budget in early October.
"It is critical that Treasury finances be brought into balance as soon as possible so that the monetary and fiscal policy mix contributes to external balance of the economy, fosters overall economic stability, and delivers inflation close to target, at the lowest possible cost," the central bank said.