Wednesday, March 15, 2017

Iceland holds rate, to ease FX volatility when needed

    Iceland's central bank left its key interest rate, the seven-day deposit rate, at 5.0 percent and said it was "too early to predict the economic impact of the most recent steps in the capital account liberalization process" and it would continue to mitigate short-term volatility in the foreign exchange market when conditions warrant.
    Iceland's government announced on Sunday that almost all of the remaining capital controls imposed during the global financial crises in 2008-2009 would be lifted as of Tuesday, resulting in an immediate fall in the exchange rate of the krona.
    The Central Bank of Iceland (CBI) noted this volatile reaction but added it is is "possible that a better balance will develop between the foreign exchange market inflows and outflows."
     Against the U.S. dollar, the krona dropped by 3.5 percent on Monday morning to 111.59 but since then it has rebounded to trade at 109.50 today but is still up 3.2 percent this year.
    The drop this week only partly reverses a 27 percent rise in the krona since March 2015, with traders attracted by higher interest rates as compared to Europe and the U.S.
    The strong krona along with low global inflation has helped offset inflationary pressures along with the central bank's tight monetary stance that has helped anchor inflation expectations and contained growth in credit and demand.
     Iceland's inflation rate was stable at 1.9 percent in February, January and December, continuing to remain below the CBI's target of 2.50 recent, as the appreciation of the krona has allowed the central bank to retain lower interest rates than would otherwise have been possible.
     Last year the CBI cut its rate by 75 basis points and today repeated its recent neutral guidance that its "monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres."
     In its monetary bulletin from February, the CBI lowered its inflation forecast for this year to 1.9 percent from a previous forecast of 2.1 percent 2016's 1.7 percent. For 2018 the CBI forecast inflation of 2.5 percent, down from 2.6 percent, and for 2019 inflation was forecast at 2.8 percent, down from 2.9 percent.
    Economic activity in Iceland accelerated sharply in the second half of 2016 with Gross Domestic Product up by an annual rate of 11.3 percent in the fourth quarter on strong consumer spending and revenue from tourism, pushing 2016 growth up to 7.6 percent, sharply higher than the 6.0 percent forecast by the central bank in February.
    "Indicators imply continued strong growth thus far in 2017," the CBI said. 
    In February the CBI forecast 2017 GDP growth of 5.3 percent and 2018 growth of 3.1 percent as domestic demand was seen rising by 5.8 percent and 3.0 percent, respectively.

    The Central Bank of Iceland issued the following statement:

"The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore remain 5%.
According to national accounts figures from Statistics Iceland, GDP growth measured 7.2% in 2016, a full percentage point more than was projected in the February issue of Monetary Bulletin. The deviation from the forecast is attributable largely to stronger-than-projected services exports and private consumption. Indicators imply continued strong growth thus far in 2017. Job creation is strong, unemployment is low, and the labour participation rate has risen above the pre-crisis peak. Even though importation of foreign labour pulls in the opposite direction, demand pressures in the economy are growing.
Inflation measured 1.9% in February, broadly similar to the level in the past six months. As before, the inflation outlook reflects two offsetting forces. GDP growth has turned out stronger than previously forecast, but the exchange rate of the króna is higher. The currency appreciation and low global inflation continue to offset domestic inflationary pressures, and the gap between domestic price developments – housing costs in particular – and external factors has widened. In addition, a tight monetary stance has anchored inflation expectations and contained both credit growth and demand growth.
It is too early to predict the economic impact of the most recent steps in the capital account liberalisation process. It is possible that a better balance will develop between foreign exchange market inflows and outflows, but short-term volatility could increase, as appears to have happened in the past few days. The Central Bank will continue to mitigate short-term volatility when conditions warrant it. 
Rapid growth in economic activity and clear signs of demand pressures in the economy call for a tight monetary stance so as to ensure medium-term price stability. On the other hand, uncertainty in the labour market has abated.
A stronger anchor for inflation expectations at target and the appreciation of the króna have enabled the MPC to achieve its legally mandated price stability objective with a lower interest rate than would otherwise have been possible. The monetary stance in the coming term will be determined by economic developments and actions taken in other policy spheres."

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