Iceland's central bank raised its main interest rates, including the seven-day deposit rate, by 25 basis points to curb inflation that is expected to exceed the bank's target next year and not return to the target until 2018.
The Central Bank of Iceland (CBI), which has now raised its rate by 125 basis points this year, said a stronger exchange rate of the krona and low global prices had provided the the scope to raise rates more slowly than envisioned but still not changed the need for a tighter monetary policy stance due to growing domestic inflationary pressures from large pay increases.
The rate rise follows the central bank's warning in September that it would raise rates further if inflation accelerates. In September the central bank maintained its rates but raised the reserve requirements by 200 basis points.
"How much and how quickly the monetary stance must be tightened will depend on future developments and how the current economic uncertainty plays out," the CBI said, noting "considerable uncertainty" about the transmission of monetary policy as the impact of unusually low global interest rates have been felt increasingly in Iceland.
Future rates will also depend on liquidity in connection with the liberalization of Iceland's capital account and whether other instruments are used to contain demand-side pressures.
Iceland's inflation rate eased to a less-than-expected 1.8 percent in October from 1.9 percent in September due to the continued fall in global oil and commodity prices and the recent rise in the krona that has helped offset domestic inflationary pressures.
"As a result, the short-term inflation outlook is considerably better than the Bank projected in August, although the longer-term outlook is broadly unchanged," the CBI said.
The CBI, which targets inflation of 2.5 percent, forecast 2015 inflation of 2.2 percent in August and 2016 inflation of 4.3 percent.
The Icelandic krona depreciated from May 2014 through March this year but since then it has appreciated and was trading at 129 to the U.S. dollar today for a net depreciation since the beginning of this year of 1.26 percent.
The CBI raised the seven-day deposit rate to 5.75 percent, the overnight CBI rates to 7.50 percent and the seven-day collateralized lending rate to 6.50 percent.
Last month Iceland repaid $332 million, or all its remaining obligations, to the International Monetary Fund (IMF), ending the rescue package that was launched in 2008 during the global financial crises.
The Central Bank of Iceland issued the following statement: