Iceland's central bank maintained its benchmark seven-day lending rate at 6.0 percent but struck a surprisingly hawkish tone by saying "robust near-term growth in domestic demand and growing tension in the labour market could generate increased inflationary pressures, however, and necessitate an increase in the bank's nominal interest rates."
However, the Central Bank of Iceland, which has held rates steady since November 2012, also said its monetary stance had tightened more than expected due to rapid disinflation and declining inflation expectations and new national accounting standards had cast a measure of uncertainty over the interpretation of data, "temporarily complicating the assessment of the appropriate monetary stance."
Iceland's consumer prices eased by 0.12 percent from August to an annual rate of 1.8 percent in September, with an annual deflation rate of 0.2 percent over the last three months.
Inflation has now been below the central bank's 2.5 percent target for the last eight months and the outlook for the coming months is for lower inflation than projected in August, the bank said.
In August the central bank estimated average 2014 inflation of 2.4 percent based on estimated third quarter inflation of 2.3 percent and fourth quarter inflation of 2.6 percent. For 2015 inflation was projected to rise to 2.8 percent and 2.9 percent in 2016.
"Inflation expectations have moved towards the target in the recent term, while long-term expectations remain somewhat above it," the bank said, adding that foreign exchange inflows have continued but its intervention in the currency market has helped stabilize the krona currency.
The krona was trading at 120.85 to the U.S. dollar today, continuing its decline from a rate of 115.05 at the start of the year. Since May, the central bank has intervened in the foreign exchange market to smooth out volatility.
Iceland's economy has slowed in the first half of this year, but the central bank said this was broadly in line with its projections.
Iceland's Gross Domestic Product contracted in the second quarter by 1.2 percent from the first quarter, the third quarterly contraction in a row. On an annual basis GDP expanded by 2.4 percent after shrinking by 1.3 percent in the first quarter.
In August the central bank forecast average 3.4 percent growth in GDP this year, with growth picking up in 2015 to 3.9 percent before easing to 2.8 percent in 2016.