Iceland's central bank kept its benchmark seven-day collateralised lending rate steady at 6.0 percent and tied future changes in its policy stance directly to the size of wage rises in upcoming settlements.
The Central Bank of Iceland, which has held rates steady this year after raising them by 125 basis points in 2012, also repeated that it's accommodative policy stance had supported the economy but it was "still the case that as spare capacity disappears from the economy, it is necessary that slack in monetary policy should disappear as well" and the degree of this normalization depends on inflation, which in turn depends on wages and exchange rate movements.
Iceland's inflation rate eased to 3.9 percent in August from 4.3 percent in July. The central bank forecast in August that inflation would rise slightly in the second half of this year and then decline toward the bank's 2.5 percent target in early 2014.
Over the last month, the Icelandic krona has been largely steady against the U.S. dollar but since the beginning of the year it has appreciated by 5.4 percent, trading at 121.17 to the U.S. dollar today.
"The Bank's intervention in the foreign exchange market has contributed to reduced exchange rate volatility," the bank said, adding that inflation expectations have not change, possibly due to uncertainty about foreign debt deleveraging, settlement of failed banks' estates, capital account liberalization and uncertainty over future wage settlements.
The central bank also said its policy had to take into account fiscal policy and noted that the latest budget proposal assumes that the primary surplus will rise and debt decline, underlining that it was important that an overall surplus be achieved as soon as possible to help foster economic stability and inflation that is close to target.
Iceland's economy expanded by an annual 4.2 percent in the second quarter for first half growth just over 2.0 percent, slightly stronger than assumed by the bank in its August forecast. The bank forecast economic growth of 1.9 percent this year and 2014 growth of 2.8 percent.
The unemployment rate eased to 4.9 percent in August from 5.0 percent and the bank said it had assumed that wage increases in the upcoming round would be larger than consistent with its inflation target.
"If wage increases are in line with the forecast, it will probably be necessary to raise the bank's nominal interest rates, other things being equal, particularly if the margin of spare capacity in the economic continues to narrow" the bank said, adding:
"If wages rise in excess of the forecast, it is even more likely that the bank will raise interest rates. If wage increases are consistent with the inflation target, however, inflation will fall more quickly than is currently predicted and interest rates will be lower than would otherwise be necessary, other things being equal."