Iceland's central bank maintained its policy rate, including the seven-day lending rate and 5.25 percent and the seven-day deposit rate at 4.5 percent, and said future rate changes would depend on pay increases in upcoming wage settlements and domestic demand.
The Central Bank of Iceland, which cut rates by 75 basis points in 2014, most recently by 50 basis points in December, added that if inflation remains below the central bank's 2.5 percent target and pay rises are in line with this target, then it might create conditions for another cut in policy rates.
However, if pay increases are large and demand grows strongly, the achieved price stability could be undermined and rates be raised.
Iceland's consumer price inflation rate was steady at 0.8 percent in January and December, but the central bank said it was slightly negative if housing costs were excluded and the outlook is for inflation to remain below 2.0 percent into 2016, below the bank's November forecast.
In November the bank cut its 2015 inflation forecast to 2.6 percent but raised its 2016 forecast to 3.0 percent.
Economic growth in the first nine months of last year was weaker than forecast and the central bank cut its projection for 2014 Gross Domestic Product growth to 2.0 percent from 2.9 percent.
However, growth in 2015 is expected to be stronger than forecast and the bank revised up its projection to 4.2 percent from 3.5 percent. The bank has forecast 2016 growth of 2.8 percent.
Iceland's GDP expanded by 3.9 percent in the third quarter from the second for an annual contraction of 0.2 percent compared with second quarter growth of 2.4 percent.
The Central Bank of Iceland issued the following statement:
"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 4.5%.
According to preliminary figures from Statistics Iceland, GDP growth was somewhat weaker in the first three quarters of 2014 than was forecast in the Bank’s November Monetary Bulletin. There are indications that these preliminary figures may be underestimated; nevertheless, the Bank’s updated forecast assumes that GDP growth in 2014 was weaker than in the November forecast, or 2% instead of 2.9%. On the other hand, GDP growth in 2015 is expected to be stronger than previously projected, or 4.2% instead of 3.5%.
Inflation has subsided still further since the last interest rate decision. It measured only 0.8% in December and January and was slightly negative if the effects of housing costs are excluded. The outlook is for inflation to remain below 2% into 2016, which is below the November forecast. Low global inflation and a stable króna contain inflation and offset the effects of considerable domestic wage increases. Inflation expectations have fallen as well in recent months and are now close to target by most measures.
In many respects, the economic outlook is more uncertain than often before. The drop in petrol prices has had a strong impact on price developments in Iceland and abroad, but it is uncertain how long these conditions will persist. Wage growth has been strong in Iceland, unlike in most trading partner countries, and mounting unrest in the domestic labour market could jeopardise the stability that has been achieved.
The Bank’s real rate has risen in the recent past, owing to declining inflation and inflation expectations. It is relatively high in view of the current business cycle position and the near-term outlook. Reductions in global fuel prices are beyond the scope of domestic monetary policy, however, and the disinflation resulting from them is temporary. Therefore, in determining interest rates, it is not possible to take full account of the disinflation stemming from this source. The outlook for the labour market is also highly uncertain, and at the same time, there are signs of strong GDP growth in the near future. For this reason, the MPC considers it appropriate to wait until the economic situation becomes clearer, particularly as regards wage developments.
As always, developments in nominal interest rates depend on developments in demand and inflation. 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."