Iceland's central bank left its benchmark interest rate on 7-day deposits unchanged at 5.25 percent and maintained its neutral bias by saying that its "monetary stance in the coming term will depend on economic developments and actions taken in other policy spheres."
The Central Bank of Iceland (CBI), which cut its rate by 50 basis points in August in the first change in rates since November 2015, added that although inflation expectations were firmly anchored and an appreciation of the krona's exchange rate had tightened monetary conditions, strong growth in domestic demand and a range of uncertainties "call for caution in interest rate setting."
Among these uncertainties are the government's fiscal stance, unrest in the labour market, continued uncertainty about the impact of the liberalization of the capital account, and the global economy.
In its latest monetary bulletin, the CBI lowered its outlook for inflation due to the strong krona.
Inflation, as measured by the consumer price index, is seen averaging 2.3 percent in 2017, down from 3.2 percent forecast in August, and 2.6 percent in 2018, down from 3.6 percent. For 2016 inflation is seen averaging an unchanged 1.7 percent and for 2019 2.9 percent.
Iceland's inflation rate was steady at 1.8 percent in October and September, below the central bank's 2.50 percent target for nearly three years as low global inflation and the rise in the krona have offset large pay increases and rapid growth in demand.
But the CBI said this change in the inflation forecast "does not provide as much scope for monetary policy response as might be expected, as the MPC (the bank's monetary policy committee) had already incorporated a strong probability of further appreciation of the currency into its recent policy decisions."
Iceland's krona has been appreciating since March 2015 and was trading at 113.1 to the U.S. dollar today, up 14.8 percent since the start of the year.
The CBI acknowledged that its tight monetary stance, which has slowed growth in demand and credit and thus inflation, had also had the effect of supporting the krona's value, lowering import prices even further and shifting demand toward imports.
Iceland recently dismantled capital controls that were put in place after 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.
So far the process of unwinding these capital controls "has been smooth," the CBI said, adding that it recently had been buying less foreign currency than earlier in the year and considers it "appropriate to continue in this vein."
The central bank's foreign exchange reserves have risen strongly in recent years as it has been buying up foreign currency inflows to build up its war chest and help prevent any possible volatility in the krona's exchange rate in response to the removal of capital controls.
Iceland's economy has been performing strongly in recent years, with growth in the second quarter of 3.7 percent, down from 4.4 percent in the first quarter.
The central bank raised its outlook for 2016 growth to 5.0 percent from a previous forecast of 4.9 parent and 2015's 4.2 percent. For 2017 Gross Domestic Product is seen expanding by 4.5 percent, up from the August forecast of 4.1 percent, and 2018 growth is seen at 2.9 percent, up from 2.6 percent. Growth in 2019 is seen at 2.7 percent.
The Central Bank of Iceland issued the following statement: