The Central Bank of Iceland last cut its rate by 50 basis points in December in response to a drop in inflation but in May said it was likely to raise rates this month due to strong wage increases, growth in demand and rising inflation expectations.
"The outlook for developments in wage costs, the increase in inflation expectations, and indicators of robust demand growth make it unavoidable to respond to the worsening inflation outlook now, even though inflation is still below target," the central bank said.
The central bank's key rates were all raised by 50 basis points so the seven-day deposit rate is 5.00 percent, the seven-day lending rate 5.75 percent and the overnight lending rate 6.75 percent.
Although inflation is still low - inflation in May rose to 1.6 percent from April's 1.4 percent - the central bank said the outlook had deteriorated markedly since its last forecast in May and it now expects inflation to exceed its forecast due to larger-than-expected wage increases.
In May the central bank raised its forecast for consumer price inflation to average 1.9 percent this year from a previous forecast of 0.7 percent, for 2016 inflation to hit 3.0 percent from 2.3 percent and 2017 inflation to rise further to 3.2 percent from a previous 2.5 percent.
The central bank targets inflation of 2.5 percent.
In contrast to inflation, Iceland's economic growth has been "broadly in line" with its May forecast, with first quarter Gross Domestic Product contracting 1.5 percent from the fourth quarter for annual growth of 2.9 percent, propelled by an almost 10 percent rise in demand.
In May the central bank raised its 2015 GDP forecast to 4.6 percent from a previous 4.2 percent, the 2016 forecast to 3.4 percent from 2.8 percent and the 2017 forecast to 3.1 percent from 2.7 percent. In 2014 the Iceland economy expanded by only 1.9 percent.
The Central Bank of Iceland issued the following statement:
"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to raise the Bank’s interest rates by 0.5 percentage points. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore be 5%.
According to newly published national accounts, GDP growth measured 2.9% in Q1/2015. Consumption and investment grew by 6.4% and domestic demand by almost 10%. These figures, together with the strong recovery of the labour market, indicate that economic activity is growing broadly in line with the Bank’s May forecast.
Although inflation is still low, the inflation outlook has deteriorated markedly from the Bank’s last forecast, and inflation expectations have continued to rise. The outlook is for higher inflation than the Bank projected in May because wage increases recently negotiated have been significantly larger than was assumed in the May forecast.
In order to facilitate the conclusion of wage settlements, the Government has announced measures that will increase public expenditures and reduce tax revenues. This will entail an easing of the fiscal stance, other things being equal, as they have not been financed. Furthermore, the authorities have announced measures aimed to prepare for liberalisation of the capital controls. Some of these measures will generate revenues for the Treasury, and it is important that these revenues be allocated so as not to stimulate the domestic economy still further, i.e. by activating the hitherto sterile component of money holdings. The MPC will monitor developments closely and will take appropriate countervailing measures if necessary. In recent MPC statements, the Committee has repeatedly pointed out that large pay increases and strong growth in demand could undermine the recently achieved price stability and require that interest rates be raised again. The outlook for developments in wage costs, the increase in inflation expectations, and indicators of robust demand growth make it unavoidable to respond to the worsening inflation outlook now, even though inflation is still below target. Furthermore, it seems apparent that a sizeable rate increase will be necessary in August, followed by further rate hikes in the coming term, so as to ensure price stability over the medium term."