Iceland's central bank held its policy rates steady but warned that interest rates would be raised as the economy's spare capacity disappears and "the degree to which such tightening takes place through changes in nominal Central Bank rates will depend on future inflation developments, which in turn will depend on wage developments and exchange rate movements."
The Central Bank of Iceland, which has held its benchmark seven-day lending rate steady this year at 6.0 percent after raising it by 125 basis points in 2012, also said the country's economy expanded by 3.1 percent in the first three quarters of this year, "considerably above the Central Bank's November forecast and is consistent with previous indications of a strong labour market recovery."
The central bank has maintained a policy tightening bias for months but appeared to ratchet up its warning about rate rises in light of a government proposal to reduce household debt.
The central bank said debt reduction would stimulate domestic demand and because spare capacity is disappearing, increased demand will raise inflation unless there is a change in the monetary stance.
Stronger demand will also tend to stimulate imports and narrow the current account surplus, which will contribute to a weaker krona. This would tend to raise inflation.
"A stronger economic recovery and the above-mentioned government measures will require more rapid monetary tightening than previously expected, other things being equal," the bank warned.
Last month Iceland's prime minister accused the central bank governor of playing "politics" after he expressed doubt over plans to offer homeowners debt relief.
Prime Minister Sigmundur David Gunnlaugsson's Progressive Party won elections in April and promised homeowners to reduce their debt. In addition to asking foreign creditors to write of some $3.6 billion of $6 billion debt that is owed to creditors of Iceland's failed banks, the government is considering setting up a fund financed by the central bank to help provide debt relief to home owners.
Central Bank Governor Mar Gudmundsson has criticized such an idea, telling a parliamentary committee that this would be "tantamount to printing money."
Last month the central bank raised its 2013 growth forecast to 2.3 percent but cut its 2014 forecast to 2.6 percent. For 2015 the bank forecast growth of 2.8 percent.
In the third quarter Iceland's Gross Domestic Product grew by 6.1 percent from the second quarter for year-on-year growth of 4.9 percent, up from 3.8 percent.
Iceland's inflation rate rose to 3.7 percent in November from 3.6 percent while the krona's exchange rate was "somewhat higher" than in November, but broadly as expected by the central bank.
Last month the central bank said it expected inflation to subside to its 2.5 percent target by end-2015 and to average 2.0 percent over its forecast horizon.
As in previous months, the central bank warned that the outcome of wage negotiations "will have a decisive effect on the inflation outlook and therefore on near-term interest rates developments" and rates are likely to rise if wage rises exceed the inflation target.
Iceland's unemployment rate fell further to 5.7 percent in October from 6.2 percent in September and the bank expects the rate to fall to about 4 percent in the fourth quarter of 2014.