On October 15, 2008, the Board of Governors of the Central Bank of Iceland announced a policy rate reduction to 12%. That decision was explained by dramatically changed circumstances in the Icelandic economy: contraction was under way, further contraction was expected, and demand and expectations had plummeted.

Last week the Icelandic Government and a mission from the International Monetary Fund concluded an agreement. One of the points in the agreement was that when it will be presented to the Executive Board of the Fund for its approval, which should happen in the next few days, the Central Bank was to have raised the policy rate to 18%. This has now been done. This decision has been taken with reference to the fact that, with the collapse of three banks and the harsh external measures that followed, Iceland's foreign exchange market became paralysed. Although the situation has eased somewhat, some restrictions continue to be inevitable.

It is of overarching importance to restore stability in the foreign exchange market and support the exchange rate of the króna. Although the real exchange rate is currently much lower than is justifiable for the long term, it is considered unavoidable to provide the króna with a firmer footing on the foreign exchange market through a restrictive policy rate as current restrictions are gradually removed. Negative real interest rates would weaken that footing. A contraction in demand will soon result in a surplus in the goods and services accounts. A negative output gap coupled with balance or surplus in the current account will contribute to the appreciation of the króna, given that trust has been restored in the foreign exchange market. If forecasts materialise, the policy rate will be reduced in accordance with rapidly subsiding inflation.

No. 41/2008
October 28, 2008