The Board of Governors of the Central Bank of Iceland has decided to leave the Bank's policy interest rate unchanged at 15.5%.

In the wake of the depreciation of the króna during the first three months of 2008, the Bank raised the policy rate by 1.75 percentage points in two increments, first in late March and then in early April. As could be expected, the fall in the exchange rate pressed inflation upwards in April, and in the months to come, inflation could rise still further than the Bank projected in its April forecast. Increased domestic costs due to the exchange rate depreciation, wage increases, and price hikes abroad will shape near-term developments to a large extent. Ultimately, however, the effects of a narrowing output gap and declining demand will dominate, and inflationary pressures will subside.

According to the Central Bank's forecast, published in the April 2008 issue of Monetary Bulletin, domestic demand will contract markedly in the next couple of years, and the housing market will cool off. While signs of the latter have been crystallising since early April, it is now apparent that demand growth is waning as well. However, there are still no clear indications of a slowdown in the labour market.

It is of paramount importance that a short-term burst of inflation not be allowed to generate a spiral of rising wages and prices and a falling króna. A high policy rate and other measures taken by the Central Bank and other authorities – including increased issuance of Government securities – are intended to foster stability in the foreign exchange market, which is an important precondition for controlling inflation and inflation expectations. The currency swap agreements between the Central Bank of Iceland and the central banks in Denmark, Norway, and Sweden had a positive effect on the market, but they do not cure all ills.

It will not be possible to relax the monetary stance until it has been demonstrated that inflation is on the wane, as few things are more important for the balance sheets of households and businesses than that disinflation begin and continue on a firm path. The Board of Governors will continue to make its policy rate decisions based on this fundamental consideration.

Nr. 17/2008
May 22, 2008