Iceland's central bank maintained its benchmark seven-day collateralised lending rate at 6.0 percent and repeated that changes in the rate were directly tied to the results of the upcoming wage negotiations and 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 of Iceland, which has held rates steady this year after raising them by 125 basis points last year, revised upwards its forecast for 2013 output growth to 2.3 percent from its August forecast of 1.9 percent while the 2014 forecast was trimmed to 2.6 percent from 2.8 percent and 2015 growth was forecast at 2.8 percent instead of 2.9 percent.
"The recovery of the labour market continues with increased strength, with total hours rising more this year than in any year since 2007," the central bank said, adding it expects the unemployment rate to fall to about 4 percent in the fourth quarter of 2014 and below that by the fourth quarter of 2016.
Iceland's unemployment rate rose to 6.1 percent in September from 4.9 percent in August, but the bank said that the seasonally adjusted unemployment rate was 4.5 percent in the third quarter, down by 0.5 to 1.0 percentage points for the year and the employment rate had risen by 2 percentage points in the same period while total hours worked rose by 5.6 percent, more than forecast in August.
Iceland's Gross Domestic Product contracted by 6.5 percent in the second quarter from the first but compared with the same quarter last year, it expanded by 4.2 percent.
In addition to the uncertainty surrounding the upcoming wage talks, the central bank said Iceland's terms of trade - or the ratio of export prices to import prices - have continued to deteriorate, eroding the current account surplus and putting pressure on the krona's exchange rate.
"Looking ahead, there is uncertainty about how foreign debt deleveraging, the settlement of the failed banks' estates, and capital account liberalisation will affect the exchange rate," the bank said.
Iceland was hard hit by the global financial crises in 2007 and its three largest banks collapsed in 2008 under the weight of $85 billion of debt, forcing an International Monetary Fund bailout. Currency controls were imposed in November 2008 to protect the Icelandic krona after it plunged in mid-2008.
Prior to the financial crises, the krona traded at around 60 to the U.S. dollar and in May this year the central bank took a more active role by intervening in the foreign exchange market to steady the exchange rate. Since the start of this year, the krone has strengthened slightly, trading at 121.6 to the U.S. dollar today compared with 128.6 at the end of 2012.
Iceland's government wants to ease currency and capital controls but is also aware that $8 billion of funds that are trapped in the country may suddenly flow out, leading to another plunge in the krona and raised the cost of foreign debt. Iceland has asked foreign creditors to write off some $3.6 billion of almost $6 billion that is owed to offshore creditors of the failed banks.
Iceland's inflation rate fell to 3.6 percent in October from 3.9 percent and the central bank forecasts gradual disinflation in coming quarters, with inflation lower than previously forecast, but in the main the outlook is broadly in line with its August forecast, with inflation expected to subside to the bank's 2.5 percent target by end-2015 and to average almost 2.0 percent over the forecast horizon.
However, the central bank also stressed that inflation would depend on the exchange rate and wage developments.
"At present, however, the upcoming wage negotiations are the most important source of uncertainty," the bank said, assuming that wage increases would be above 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 economy continues to narrow," the bank said.
"If wages rise in excess of the forecast, it is even more likely that the bank will raise interest rates," it said, adding that if wage rises are in line with the inflation target, inflation would fall and interest rates would be lower than necessary.