The Central Bank of Iceland raises its policy rate
The Board of Governors of the Central Bank of Iceland has decided to raise the policy rate by 1.25 percentage points to 15%. The assumptions underlying the inflation forecast published in Monetary Bulletin in November 2007 entailing an unchanged policy rate until after the middle of this year have not held.

Inflation has been higher than forecast and inflation expectations have risen. Demand has also been stronger than was expected. The exchange rate of the króna has depreciated more than entailed in an alternative scenario published in Monetary Bulletin in November. It assumed that such a development would be met with a higher policy rate. The real exchange rate of the króna is now very near a long term historical low which it reached in November 2001. If that development is not reversed and a period of persistent inflation would be ahead with spiralling increases in prices, wages and the price of foreign exchange. The depreciation of the króna in recent weeks also undermines the Balance Sheet of indebted households and businesses and thus financial stability looking further ahead. It is therefore crucial that the depreciation of the króna is reversed as quickly as possible.

Deteriorating financial conditions in global markets mean that it has become more difficult to finance current account deficit. Adjustment of the national economy with a contraction of demand will thus be not escaped. It will only be more painful if inflation if inflation is allowed to get out of hand. Consequently, it will be necessary to continue to pursue a very tight monetary policy in order to bring inflation and inflation expectations under control and increase confidence in the króna.

On Thursday April 10, the Central Bank of Iceland will issue its Monetary Bulletin with a new national economic forecast and an inflation forecast. At the same time the Board of Governors will announce its decision on interest rates.

No. 10/2008
March 25, 2008