Iceland's central bank held its policy rates steady but warned that "the outlook for stronger domestic growth will require that the monetary stance be tightened sooner and more than previously expected."
The Central Bank of Iceland, which maintained its benchmark seven-day lending rate at 6.0 percent in 2013 after raising it by 125 basis points in 2012, raised its forecast for growth and inflation due to the government's debt relief measures that the bank's expects will "boost private consumption considerably in the near future."
The pace of the central bank's rate tightening will depend on inflation - the central bank targets inflation of 2.5 percent - along with the government's fiscal policy, the central bank added.
In its latest Monetary Bulletin the bank revised upwards its estimate for Iceland's Gross Domestic Product growth in 2013 to 3.0 percent from its November forecast of 2.3 percent, helped by a strong recovery in the labour market and trade. The forecast for this year and the following two years has also been revised up so the slack in the economy will disappear earlier than expected.
Iceland's GDP is forecast to expand by an unchanged 2.6 percent in 2014 but then grow by 3.7 percent in 2015, up from a previously-expected 2.8 percent, and by 3.0 percent in 2016, up from 2.0 percent forecast in November.
"If the forecast materializes, output growth will average 3.1 percent over the forecast horizon, which is above the 30-year average and well above the average projection for Iceland's main trading partners," the bank said.
Inflation in 2014 is expected to ease to an average of 2.7 percent, down from an estimated 3.9 percent in 2013, and lower than 3.2 percent forecast in November. The reason for the lower-than-expected inflation rate is because the rise in unit labour costs will be smaller than forecast by the bank provided that the wage talks concluded in December would be applied to the entire labor market.
In January Iceland's headline inflation rate eased to 3.1 percent from 4.2 percent in December.
"The inflation outlook for the coming two years has deteriorated since the November forecast, however, as the outlook if for the slack in the economy to give way to an output gap during the period," the central bank said.
In 2015 the bank expects inflation to average 3.4 percent, up from a previous 2.8 percent forecast, and 3.2 percent in 2016, up from 2.6 percent.
The central bank's latest survey of market expectations from early February showed the bank's collateralised lending rate remaining unchanged at 6.0 percent until the end of 2014, 0.5 percentage points lower in nominal terms than in the November survey.
But markets currently expect the central bank to raise its rate by 25 basis points in the first quarter of next year, rising to 6.5 percent in two years. Forward rates indicated that investors expect the bank's policy rate to by by 50 basis points this year, 25 basis points higher than forward rates indicated in November.
The government's debt relief package will be implemented over four years, estimated to cost 150 billion Icelandic krona, or 8.5 percent of the estimated value of Iceland's GDP in 2013.
The central bank projects the measures will boost private consumption by 1.5 percentage points in 2014 and 2015, partly crowding out investment, but boosting GDP growth by about 0.2 percentage points. Imports will also rise, leading to a 1.0-1.5 percentage points drop in the forecast for the current account balance, putting pressure on the krona, which will boost inflation.
Iceland's current account balance was estimated at a surplus of 3.0 percent of GDP in 2013, but this would decline to a surplus of only 0.8 percent this year, a deficit of 1.0 percent in 2015 and a deficit of 2.8 percent in 2016.
Private consumption in Iceland is now forecast to expand by 4.6 percent this year, up from an estimated 1.6 percent in 2013 and a previous forecast of 2.3 percent. In 2015 private consumption is forecast to rise by 4.3 percent, up from a previous 2.5 percent, and by 2.9 percent in 2016, up from 2.5 percent previously forecast.
"In part the effects of the debt relief package are absorbed through higher interest rates," the bank said.
According to the bank's quarterly macroeconomic monetary policy rule, the central bank's policy rate will be some 0.3 percentage points higher than previously forecast in 2014, 0.6 percentage points higher in 2015 and nearly 1 percentage point higher from 2016.
"Higher interest rates therefore offset the impact of the debt relief measures on domestic demand, the exchange rate of the krona, and inflation," the bank said in its bulletin.
However, the bank cautioned there was a great deal of uncertainty about the impact of the package due to the lack of historical precedent. Households could save more than assumed, growth and inflation will depend on how much the increased demand is directed toward imports versus domestic factors, and this will again affect the exchange rate. The government could also act to mitigate some of the negative effects of the measures, it said.