Iceland's central bank maintained its policy rates and cut its inflation forecast but raised the growth forecasts, saying "whether a change in the Bank's nominal interest rates is warranted in the near future will depend on the future path of inflation and inflation expectations."
In March the Central Bank of Iceland, which has held its benchmark seven-day lending rate at 6.0 percent since November 2012, toned down earlier warnings of the need for tighter monetary policy due to stronger-than-expected economic growth.
And while the central bank raised its growth forecast in its latest monetary bulletin, inflation and inflationary expectations have declined with the result that the bank's real effective interest rate has risen "markedly" and the previous slack in the monetary stance "has probably disappeared."
Iceland's headline inflation rate fell to 2.3 percent in April and averaged 2.5 percent in the first quarter compared with a first quarter 2013 average of 4.3 percent and 6.4 percent in first quarter 2012. The central bank targets inflation of 2.5 percent.
The Bank's effective real interest rate is about 3.0 percent, up just under one percentage point in the past year and above the rate in other industrialized countries. Financial markets have adjusted to this, the bank said, primarily because long-term inflation expectations are not yet firmly anchored.
The central bank revised down its inflation forecast for 2014 to 2.5 percent from its February forecast of 2.7 percent, the 2015 forecast to 3.1 percent from 3.4 percent, but raised the 2016 forecast to 3.3 percent from 3.2 percent.
The improved inflation outlook is mainly due to the stronger Icelandic krona and smaller rises in labour costs than previously expected.
Short-term inflation expectations have also declined by about one percentage point with a March survey of business executives projecting inflation two years ahead at 3.5 percent, the lowest survey valued since autumn 2008. But long-term inflation expectations have been more persistent, the bank said, with the 10-year rate of about 4.0 percent, broadly unchanged since February and May 2013.
The central bank expects economic slack to disappear by mid-2014, with inflation beginning to inch up as the year progresses, rising above 3.0 percent in the first half of 2015 when the effects of the appreciation of the krona will have tapered off and a positive output gap developing.
The central bank revised upwards its growth forecast, with Gross Domestic Product now seen expanding by 3.7 percent this year, up from 2013's growth of 3.3 percent and the February forecast of 2.6 percent.
GDP growth in 2015 is seen at 3.9 percent, up from 3.7 percent, while the 2016 growth forecast was revised down to 2.7 percent from 3.0 percent.
Although the central bank assumes that wage agreements from late last year will apply to most of the labour market, it said there was still some unrest in the market, causing uncertainty.
Higher economic growth could require increases in the bank's interest rates, but other measures, including tight fiscal policy, would help ease the need for tighter monetary policy and also help raise the national savings rate and lead to a more favorable current account balance, the bank said.
The bank's monetary policy committee has recently discussed changes to its policy instruments to improve liquidity management and help prepare for the liberalization of capital controls and the sale of central bank assets.
The bank has now decided to discontinue weekly sales of 28-day certificates of deposits, replacing them with two types of deposits that will be eligible as collateral for loan facilities. Each week, term deposits of one week will be offered at a fixed rate and each month the bank will offer term deposits of one month in an auction. The first auction will be June 4.
Iceland is still trying to exit capital controls that were imposed in 2008 after the collapse of the country's three biggest banks led to a plunge in the krona currency and the worst recession in six decades.
But last year the krona rose 10 percent against the U.S. dollar and this year it has continued to rise, though at a slower pace than last year.
Today the krona was quoted at 112.6 to the dollar, up 2.1 percent since the start of the year, with the continued rise in foreign tourists and the external trade surplus helping shore up the currency. The central bank has taken a more active role since last May by intervening in foreign exchange markets.