Iceland's central bank raised its key interest rates by a further 50 basis points, as widely expected, and said it "will have to raise interest rates still further in order to bring inflation back to target" if inflation rises in the wake of wage settlements, as it expects.
The Central Bank of Iceland raised its rate by 50 basis points in June in response to strong wage increases and warned that a "sizable rate increase will be necessary in August."
It has raised its key rates by 100 basis points this year compared to a cut of 75 points in 2014.
In today's statement the central bank said the size of the future rate hikes would depend on how much the large pay increases are passed on to prices and how much productivity grows, along with such factors as terms of trade, credit growth, real estate prices and how much other policy instruments are used to contain demand-side pressures.
All the central bank's key rates were raised by 50 basis points so the seven-day deposit rate is 5.50 percent, the seven-day lending rate 6.25 percent and the overnight lending rate 7.25 percent.
In response to recent wage settlements, the central bank raised its forecast for 2015 consumer price inflation to 2.2 percent from May's forecast of 1.9 percent, the 2016 forecast to 4.3 percent from 3.0 percent and the 2017 forecast to 4.1 percent from a previous 3.2 percent.
"The inflation outlook has deteriorated markedly since the last forecast, owing to the recent wage settlements, inflation expectations have risen," the central bank said.
Iceland's inflation rate in July rose to 1.9 percent from June's 1.5 percent, still below the bank's target of 2.5 percent.
In its latest monitor bulletin, the central bank lowered its forecast for Gross Domestic Product growth this year to 4.2 percent from May's forecast of 4.6 percent, while the 2016 forecast was trimmed to 3.0 percent from 3.4 percent and the 2017 forecast to 2.8 percent from 3.1 percent.
But the central bank still described economic growth as "robust" and a positive output gap will widen to 1.1 percent of potential output this year from zero in 2014, with growth driven by domestic demand, which is forecast to expand by 6.8 percent this year, 4.4 percent in 2016 and 2.8 percent in 2017.
Iceland's GDP contracted by 1.5 percent in the first quarter of this year from the previous quarter for annual growth of 2.9 percent, down from 3.0 percent in the fourth quarter of 2014.
The Central Bank of Iceland issued the following statement: