Oct. 15 (Bloomberg) -- Iceland's central bank slashed its benchmark interest rate by 3.5 percentage points in a bid to prevent the failure of the country's three largest banks from pushing the economy into a prolonged depression.

Policy makers cut the repo rate by a record amount to 12 percent at an unscheduled meeting today, the Reykjavik-based bank said in a statement on its Web site.

Iceland's economy may contract as much as 10 percent, according to Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen, after the collapse of the banks sent the krona into a tailspin. The rate cut indicates the central bank has given up on controlling inflation, which may accelerate to as much as 75 percent in the next few months, Christensen predicts.

``This is a rate cut that will have absolutely no effect whatever on the economy,'' Christensen said. ``I'm not particularly impressed by the decisions being made by the monetary authorities in this situation. This just reminds me of last week's attempt to peg the currency.''

The krona hasn't been traded between banks outside of Iceland this week after the central bank tried and failed to fix its value the week before. Its value remains ``undetermined,'' BeatSiegenthaler, chief strategist for emerging markets at TD Securities Ltd. in London, wrote in a note today.

Iceland's benchmark stock index yesterday plunged 77 percent, the biggest decline on record, after trading resumed following a three-day suspension.

`Unprecedented Turbulence'

``The Icelandic economy has been subjected to unprecedented turbulence in the past few weeks,'' Sedlabanki said in today's statement. ``A variety of jobs have disappeared virtually in the blink of an eye, demand has declined precipitously. The impact of the collapse of the banking system will be extremely burdensome and the accompanying economic contraction very sharp.''

Iceland's financial regulator took control of Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Bank hf last week, after they couldn't secure short-term funding. That precipitated the collapse of the krona.

The currency's bid/ask spread, the price at which traders are willing to buy and sell, was 300/450 per euro on Oct. 10, according to TD Securities. That compares with the 131 rate against the euro the central bank had tried to stabilize the currency at last week.

``They're using all kinds of instruments'' such as the rate cut and the failed currency peg ``for something what's essentially a funding crisis, and it's not working,'' Christensen said.

Mercy

Iceland needs to ``throw'' itself at the mercy of the International Monetary Fund, according to Richard Portes, president of the London-based Center for Economic Policy Research.

An IMF mission is on the Atlantic island putting together a plan. Aside from lending to the government, the IMF can also provide advice to the government on rebuilding the financial system and resuscitating the currency. The government will decide whether to accept the IMF's help after seeing a plan, Prime Minister Geir Haarde said yesterday.

The nation is also turning to Russia for help after efforts to get aid from western governments failed. An Icelandic delegation started talks in Moscow yesterday to secure an emergency loan of as much as 4 billion euros ($5.47 billion).

Haarde yesterday told local broadcaster RUV the central bank needs to ``review very thoroughly'' its high interest rate policy, indicating the government has been putting pressure on Sedlabanki to deliver a rate cut.

`Paradoxical'

``This is nothing more than a symbolic move,'' Christensen said. ``It's somewhat paradoxical that an inflation-targeting bank in a situation where inflation might jump to about 75 percent is cutting rates.''

The rate cut is unlikely to restore confidence in the ability of the economy's policy makers to manage the current crisis, according to Christensen. At the same time, credit agencies don't expect the banks to be able to honor their foreign liabilities to bond investors. The government has so far failed to respond to questions on how it plans to pay back foreign bank debt.

Standard & Poor's rates Glitnir D, reflecting the agency's view that there ``will be a general default,'' according to a note published Oct. 9. S&P doesn't rate Kaupthing or Landsbanki.

To contact the reporters on this story: Tasneem Brogger in Copenhagen at tbrogger@bloomberg.net;

Last Updated: October 15, 2008 07:23 EDT