Icelandic Rate Hike

August 20, 2011

On August 17, Sedlabanki’s Monetary Policy Committee authorized the first increase of its seven-day collateralized interest rate since an IMF-mandated three percentage point jump to 18% in late October 2008.  From March 2009 through February 2010, fifteen ensuing rate cuts had slashed the key rate all the way to 4.25%, where such remained for the rest of last year and following meetings this year in February, April, and June.  However, officials had released a more hawkish message after the June 15th meeting, warning of a possible need in the near term to tighten policy to contain expected inflation in light of excessive pay agreements, rising actual inflation, a more expansionary fiscal policy and pressure on the krona.

Tuesday’s statement accompanying the 25-basis point rate hike to 4.5% returns to those themes and signals that more tightening could be coming.

Developments in recent months have increased the risk that higher inflation expectations and a weak currency will cause inflation to become entrenched, particularly once economic recovery gains pace. In the worst-case scenario, the expectation of higher inflation, a negative real interest rate, and a narrow risk-adjusted interest rate differential with major trading partners could further undermine the króna and cause a spiral of rising inflation and falling exchange rate, although the amount of spare capacity in the economy should mitigate such a development to some extent.  In order to reduce the risk of such a turn of events, it is necessary to act now to contain inflation and reduce potential pressure on the króna. This may call for further interest rate hikes. As always, however, monetary policy decisions will depend on recent developments and prospects.

Icelandic CPI inflation accelerated within six months from 1.8% in January to 5.0% last month.  Core rose from 1.2% to 3.3% over that span.  Officials target inflation at 2.5% and now believe that such a goal will not be attained until the second half of 2013. 

Officials are quite aware of the intensifying global turmoil but on Tuesday felt that a 25-basis point rate hike would not undermine domestic demand and the Icelandic jobs market, which have developed more strongly than they anticipated.  The point is made that “the past few months’ steep decline in short-term real interest rates is only reversed to a small degree” by their decision to lift the key central bank rate to 4.5%.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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