Iceland's central bank maintained its benchmark seven-day lending rate at 6.0 percent and softened its earlier warnings of a possible need to raise interest rates, saying "the slack in the monetary policy stance has probably disappeared, and it appears, based on the Bank's baseline forecast, that the current interest rate will suffice to keep inflation at target."
The Central Bank of Iceland, which has held its rate steady since November 2012, said that its updated forecast shows that the outlook for inflation has improved since the May forecast while growth this year will be slightly less than expected although domestic demand will be stronger.
"It now appears that inflation will remain close to target during the forecast horizon," the central bank said, with a positive output gap forecast to develop later and be less pronounced than assumed in the previous forecast.
The central bank's guidance today compares with its guidance from June when it said increased growth in domestic demand would probably require further increase in the bank's real rate but whether this required higher nominal rates would depend on inflation and inflation expectations.
The central bank, which in June resumed regular purchases of foreign currency, said its foreign exchange transactions had contributed to greater exchange rate stability and it intends to continue these regular purchases in the current amounts as long as conditions remain the same.
"As before, the Bank will intervene in the foreign exchange market as needed to mitigate exchange rate volatility," the bank said, adding this year it had bought "significantly" more foreign currency than it had sold.
Since May, the central bank has bought 33 billion Icelandic krona on the foreign exchange market for year-to-date purchases of about 61 billion, more than over the preceding three years, the bank said.
The Icelandic krona was trading at 116.24 to the U.S. dollar today, down 1 percent this year and after rising strongly during 2013 when it began the year at 128 to the dollar.
In May and November the central bank issues in-depth economic forecast and these are updated in August and February.
Iceland's Gross Domestic Product contracted by 0.7 percent in the first quarter from the previous quarter for annual shrinkage of 0.1 percent, considerably weaker than the central bank's May forecast of 4.1 percent growth. But this was mainly due to one-off items, such as inventory changes and net trade, that the central bank said did not reflect underlying developments.
But domestic demand still expanded by an annual 2.1 percent in the first quarter and the central bank now projects a 3.4 percent expansion in GDP this year, 0.3 percentage points below the May forecast but similar to the rate in 2013.
As in the May forecast, growth is expected to gain momentum in 2015 due to strong domestic demand and exports, rising by 3.9 percent and then easing in 2016 to 2.8 percent.
Inflation in the second quarter averaged 2.3 percent, 0.1 percentage points below the bank's May forecast and in July it rose to 2.4 percent.
The outlook for inflation in the short term is similar to May, with third quarter inflation estimated at 2.3 percent, 0.2 percentage points below the May forecast.
For the fourth quarter, inflation is forecast at 2.6 percent, similar to the May forecast which called for average 2014 inflation of 2.4 percent, rising to 2.8 percent in 2015 and 2.9 percent in 2016, slightly above the central bank's 2.5 percent target.