The Central Bank of Iceland (CBI) has now cut its rate by 75 basis points this year following a 50-point cut in August.
Although inflation has remained below the central bank's 2.50 percent target for nearly three years despite large pay rises and strong demand, the CBI said inflation expectations were more firmly anchored to its target than before, giving it scope to lower nominal rates.
"Nevertheless, strong demand growth and the aforementioned uncertainties call for caution in interest rate setting," the CBI said, adding today's rate cut reflected the bank's latest forecast and "more recent information."
Iceland's inflation rate rose to 2.1 percent in November from 1.8 percent in October but has been held back by low global inflation and demand, the strong krona and the bank's tight policy stance.
Last month the CBI forecast 2016 inflation of 1.7 percent, rising to 2.3 percent in 2017 and 2.6 percent in 2018.
Attracted by its relatively high interest rates, Iceland's krona has been firming since March 2015 and was trading at 112.7 to the U.S. dollar today, slightly down on the day but up 15.2 percent since the start of this year.
Since the November meeting by the central bank's monetary policy committee, the krona's exchange rate has risen 1.5 percent and is already above the CBI's projected average for 2017.
The recent composition of economic activity in Iceland is also more favorable than the CBI had forecast in November, with exports and business investment better than expected. As before, the central bank said there was considerable uncertainty about the fiscal policy and there is unrest in the labour market and uncertainty about the impact of the capital account liberalisation.
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.
Last month the central bank said the process of unwinding these capital controls had been smooth and it had been buying less foreign currency than earlier in the year.
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 Gross Domestic Product grew by 4.7 percent in the third quarter from the second quarter, which grew 1.7 percent, for the strongest rise since the first quarter of 2004. On an annual basis, GDP was up 10.2 percent compared with 3.8 percent in the second quarter.
Last month the CBI raised its outlook for 2016 growth to 5.0 percent from a previous forecast of 4.9 percent and 2015's 4.2 percent. For 2017 GDP was 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.