24 Aug

Iceland cuts rate 50 bps, capital flows to determine future

August 24, 2016

By CentralBankNews.info
    Iceland’s central bank cut its key policy rate, the seven-day deposit rate, by 50 basis points to 5.25 percent but said uncertainty from a liberalization of the country’s capital account argued for caution in setting interest rates and any further lowering or even raising rates “will depend on economic developments and on the success of the capital account liberalization process.”
    It was the first change in rates by the Central Bank of Iceland (CBI) since a 25-basis-point increase in November 2015 and the first rate hike since November 2012.
    The rate cut follows a much-improved outlook for inflation and the central bank’s guidance in June that it would probably have to tighten its policy stance in light of growing inflation pressures.
   But the CBI said there “are indications that monetary policy has been more successful than was expected earlier in the year,” and now 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.”
    In its latest monetary bulletin, the central bank lowered the forecast for consumer price inflation, excluding the effect of indirect taxes, this year to an average of 1.7 percent from 2.1 percent forecast in the May bulletin, below the CBI’s 2.50 percent target.
    For 2017 inflation, inflation is now seen at 3.2 percent, down from 4.1 percent and for 2018 at 3.6 percent from 3.8 percent.
    Iceland’s inflation rate fell to 1.1 percent in July, the lowest rate since early 2015, with an rise in the krona’s exchange rate, low global inflation and tight monetary policy offsetting the impact of wage increase on consumer prices.
    Iceland is in the final stage of dismantling remnants of capital controls that were put in place following 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.
    Earlier this week the central bank concluded that capital can be expected to flow out of Iceland next year due to firms’ foreign investments and individuals’ interest in diversifying their portfolios, but the risk of substantial outflows is mitigated by the wide interest rate differential, Iceland’s stronger economy, low inflation and trade-related capital inflows in connection with the higher krona.
    Annual overseas investment by Iceland’s pension sector was forecast by the central bank to amount to a relatively low level of between 60 billion and 80 billion krona from 2017 and onwards, with less pent-up need for overseas investments following several exemptions since last summer that is allowing 80 billion krona to flow out by the end of September.
    After plunging from November 2007 to November 2008 to a rate of around 143 to the U.S. dollar, the krona has been trading in a much narrower range and has been firming since March 2015.
    Today the Icelandic krona was trading at 116.8 to the dollar, up 11.1 percent since the start of this year, despite what the CBI described as “substantial foreign currency purchases.”
    “If the exchange rate remains unchanged, the outlook is for inflation to remain below target until early 2017,” the CBI said, adding that inflation will then start to rise as import prices stop falling and the impact of the currency appreciation subsides. However, if the krona continues to rise, inflation will be lower than forecast.
    In its monetary bulletin, the central bank also upgraded its outlook for economic growth, with output this year seen rising by 4.9 percent, up from 4.5 percent forecast in May and 4.0 percent in 2015 as private consumption rises by 6.7 percent, up from a previous forecast of 6.0 percent.
    For 2017 the central bank forecasts economic growth of 4.1 percent, slightly up from the May forecast of 4.0 percent and 2.6 percent in 2018, down from 3.0 percent.

    The Central Bank of Iceland issue the following statement:
 

“The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to lower the Bank’s interest rates by 0.5 percentage points. The Bank’s key interest rate – the rate on seven-day term deposits – will therefore be 5.25%. 
According to the Central Bank’s updated forecast as published in the most recent Monetary Bulletin, the outlook is for somewhat stronger output growth this year than was forecast in May, or 4.9%, followed by robust growth in 2017. In spite of large pay increases and a wider positive output gap, inflation has remained below target for two-and-a-half years. In July it measured 1.1%, the lowest inflation rate since the beginning of 2015. Improved terms of trade, low global inflation, tight monetary policy, and the appreciation of the króna have offset the effects of wage increases on the price level. The króna has appreciated markedly in the recent term, in spite of substantial foreign currency purchases by the Central Bank. 
The inflation outlook has improved since the Bank’s last forecast. If the exchange rate remains unchanged, the outlook is for inflation to remain below target until early 2017. According to the forecast, it will edge upwards when import prices stop declining and the effects of the currency appreciation subside. Inflation will rise more slowly than previously forecast, however, and will not be as high as was previously projected. If the exchange rate continues to rise, and other things being equal, inflation will be lower than is provided for in the baseline forecast. 
Tight monetary policy has contained demand for credit and led to increased saving, thereby supporting a larger current account surplus and a stronger króna. Alongside favourable external conditions, monetary policy has therefore led to lower inflation and recently to a better alignment of inflation expectations to the target. For the same reasons, 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 liberalisation 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 liberalisation process.”
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