The Central Bank of Iceland, which has now cut rates by 75 basis points following a 25 point cut in November, said the outlook for near-term inflation had declined further from November and is now expected to be "markedly below target at least through 2015."
The central bank targets inflation of 2.5 percent.
Iceland's consumer price inflation fell to 1.0 percent in November from 1.9 percent in October and was slightly negative excluding housing costs. Low global inflation and a stable krona exchange rate have contained inflation in spite of considerable wage increases, the central bank said.
Last month the central bank cut its 2014 headline inflation forecast to 2.2 percent from 2.4 percent while the 2015 forecast was cut to 2.6 percent from 2.8 percent. The 2016 forecast was raised to 3.0 percent from 2.9 percent and 2017 inflation was forecast at 2.7 percent.
The central bank also lowered its forecast for economic growth, with the 2014 forecast for Gross Domestic Product cut to 2.9 percent from 3.4 percent forecast in August, and the 2015 forecast cut to 3.5 percent from 3.9 percent. The 2016 growth forecast was maintained at 2.8 percent and growth in 2017 was seen at 2.3 percent.
In the third quarter of the year, Iceland's GDP expanded by 3.9 percent from the second quarter, the first quarterly expansion in 12 months. But on an annual basis, third quarter GDP contracted by 0.2 percent after an increase of 2.4 percent in the second quarter.
The Central Bank of Iceland issued the following statement:
"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to lower the Bank’s interest rates by 0.5 percentage points.
According to the most recent national accounts figures, GDP growth –private consumption growth in particular – is likely to be weaker this year than was previously forecast. These figures deviate markedly from other indicators of domestic demand growth, however, including imports and various measures of turnover. The recovery of the labour market continues, although growth in labour demand has lost pace somewhat. The near-term outlook is for strong growth in domestic demand and GDP.
Inflation fell to 1% in November and was slightly negative excluding the housing component. Low global inflation and a stable króna have contained inflation in spite of considerable wage increases. As a result, the outlook for the near term is for lower inflation than was expected at the time of the November interest rate decision. Inflation is therefore likely to be markedly below target at least through mid-2015. Inflation expectations have fallen as well in recent months and, by most measures, are now close to target.
In spite of the nominal interest rate reduction in November, the Bank’s real rate has risen further, owing to the significant decline in inflation and inflation expectations, and is higher than is warranted by the business cycle position and the near-term outlook. It is therefore appropriate to offset a portion of this increase.
As always, the nominal interest rate path will depend on developments in demand and inflation. The effective policy rate is now close to the level consistent with full capacity utilisation and inflation at target. If inflation remains below target and pay increases in upcoming wage settlements are consistent with the inflation target, conditions for further reductions in nominal interest rates could develop. Large pay increases and strong growth in demand could undermine the recently achieved price stability, however, and require that interest rates be raised again. "