Iceland's central bank cut its key policy rate, the seven-day deposit rate, by 50 basis points to 5.25 percent but said uncertainty from a liberalization of the country's capital account argued for caution in setting interest rates and any further lowering or even raising rates "will depend on economic developments and on the success of the capital account liberalization process."
It was the first change in rates by the Central Bank of Iceland (CBI) since a 25-basis-point increase in November 2015 and the first rate cut since December 2014.
The rate cut follows a much-improved outlook for inflation and the central bank's guidance in June that it would probably have to tighten its policy stance in light of growing inflation pressures.
But the CBI said there "are indications that monetary policy has been more successful than was expected earlier in the year," and now it "appears that it will be possible to keep inflation at target over the medium term with a lower interest rate than was previously considered necessary."
In its latest monetary bulletin, the central bank lowered the forecast for consumer price inflation, excluding the effect of indirect taxes, this year to an average of 1.7 percent from 2.1 percent forecast in the May bulletin, below the CBI's 2.50 percent target.
For 2017 inflation, inflation is now seen at 3.2 percent, down from 4.1 percent and for 2018 at 3.6 percent from 3.8 percent.
Iceland's inflation rate fell to 1.1 percent in July, the lowest rate since early 2015, with an rise in the krona's exchange rate, low global inflation and tight monetary policy offsetting the impact of wage increase on consumer prices.
Iceland is in the final stage of dismantling remnants of capital controls that were put in place following the global financial crises in 2008 that led to the collapse of its banking system and a halving of the value of the Icelandic krona.
Earlier this week the central bank concluded that capital can be expected to flow out of Iceland next year due to firms' foreign investments and individuals' interest in diversifying their portfolios, but the risk of substantial outflows is mitigated by the wide interest rate differential, Iceland's stronger economy, low inflation and trade-related capital inflows in connection with the higher krona.
Annual overseas investment by Iceland's pension sector was forecast by the central bank to amount to a relatively low level of between 60 billion and 80 billion krona from 2017 and onwards, with less pent-up need for overseas investments following several exemptions since last summer that is allowing 80 billion krona to flow out by the end of September.
After plunging from November 2007 to November 2008 to a rate of around 143 to the U.S. dollar, the krona has been trading in a much narrower range and has been firming since March 2015.
Today the Icelandic krona was trading at 116.8 to the dollar, up 11.1 percent since the start of this year, despite what the CBI described as "substantial foreign currency purchases."
"If the exchange rate remains unchanged, the outlook is for inflation to remain below target until early 2017," the CBI said, adding that inflation will then start to rise as import prices stop falling and the impact of the currency appreciation subsides. However, if the krona continues to rise, inflation will be lower than forecast.
In its monetary bulletin, the central bank also upgraded its outlook for economic growth, with output this year seen rising by 4.9 percent, up from 4.5 percent forecast in May and 4.0 percent in 2015 as private consumption rises by 6.7 percent, up from a previous forecast of 6.0 percent.
For 2017 the central bank forecasts economic growth of 4.1 percent, slightly up from the May forecast of 4.0 percent and 2.6 percent in 2018, down from 3.0 percent.
The Central Bank of Iceland issue the following statement: