Central Bank of Iceland

August 24, 2016

Icelandic monetary authorities implemented their first interest rate change, a reduction of 50 basis points, since a hike last November and their first rate cut since December 2014. Moreover, forward guidance on future rate changes switched from a bias toward increases to an ambivalent signal. After the Monetary Policy Committee’s prior meeting in early June, officials had observed that “there are signs that monetary policy has anchored inflation expectations more securely than before and contributed to a more moderate rise in inflation than could have been expected in the wake of large pay increases.” But today’s statement contains a different signal:

Real interest rates have risen somewhat more in the recent term than was provided for in the Bank’s previous forecasts based on an unchanged exchange rate. There are indications that monetary policy has been more successful than was expected earlier this year. As a result, it appears that it will be possible to keep inflation at target over the medium term with a lower interest rate than was previously considered necessary. The likelihood of increased macroeconomic imbalances and the uncertainty associated with capital account liberalization argue for caution in interest rate setting, however. Whether interest rates will be lowered further or need to be raised again will depend on economic developments and on the success of the capital account liberalization process. [bold added]

The modified policy outlook reflects lower inflation than assume, a stronger krona, and a larger current account surplus. Different facts require different policy responses, and the incremental change of 50 basis points rather than 25 bps puts an exclamation point on the action. The new levels for the Central Bank of Iceland’s 7-day term deposit rate becomes 5.25%, and the 7-day collateralized lending rate is 6.0%. Iceland’s economy has come a long way since the 7-day collateralized lending rate peaked at 18% in February of that year.

Copyright 2016, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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