Iceland Raises Interest Rates Second Time, Signals More

(RTTNews) - Iceland's central bank raised interest rates for the second consecutive rate-setting session, as signaled in the previous policy meeting in June, and hinted that they may be hiked further in order to bring inflation back to target.

The Monetary Policy Committee of the Sedlabanki on Wednesday decided to raise interest rates by 50 basis points, thereby hiking the benchmark seven-day collateralized lending to 6.25 percent. The move was in line with economists' expectations.

Previously, the bank raised interest rates by 50 basis points on June 10, which was the first rate hike since November 2012.

"If inflation rises in the wake of the wage settlements, as is forecast, the MPC will have to raise interest rates still further in order to bring inflation back to target over the medium term," the bank said in a statement.

The bank said how much and how quickly interest rates will be hiked "will depend on future developments and on how the current uncertainty plays out".

"In addition, the interest rate path will depend on whether other policy instruments are used to contain demand-side pressures in the coming term," the bank said.

The bank forecast GDP growth to be just over 4 percent this year and about 3 percent in the next two years. The latest projections were lower than the bank's May predictions.

Nevertheless, the bank expect growth to be robust. "A positive output gap will widen in the coming term, with GDP growth driven by domestic demand - especially private consumption - to a greater extent than in recent years. Investment will be weaker than previously forecast, however, and labor demand will grow more slowly," it added.

Despite recent acceleration, inflation remains below target, especially after removing the housing component, the bank noted. It also added that the inflation outlook has deteriorated markedly since the May forecast due to wage settlements. Inflation expectations have also risen, the bank said.

Sedlabanki forecast inflation to climb to 4 percent early next year and to hover in the 4-4.5 percent range over the next two years, before moving back to the target. "The forecast implies that the monetary stance will be tightened in the near future," the bank said.

"Today's rate hike by Iceland's central bank is likely to be part of a sustained tightening cycle to counter strong domestic demand growth and inflationary pressures," Capital Economics European Economist Jessica Hinds said.

The economist, however, pointed out a complicating factor, which is the central bank intervention in the foreign exchange market to counter upward pressure on the Icelandic krona linked to increased tourism and capital inflows. Since a stronger currency tends to dampen inflationary pressures, this might seem at odds with the rest of the Sedlabanki's policy, she noted.

"But the central bank is aiming to keep the krona stable and to build up its FX reserves to increase its capability to offset any balance of payments shocks that might occur when capital controls are lifted," Hinds added.