June 4 (Bloomberg) -- Iceland’s central bank lowered the benchmark interest rate by a percentage point, defying the International Monetary Fund, as the economy slumps into its worst recession in 60 years.

The repo rate was cut to 12 percent from 13 percent, Reykjavik-based Sedlabanki said on its Web site today. The rate cut is the fourth since the island received a $5.1 billion IMF- led bailout in November.

Policy makers bowed to pressure from labor unions and businesses for lower rates to soften a recession that the bank estimates will culminate in an economic contraction of 11 percent this year. IMF Mission head to Iceland, Mark Flanagan, last week advised against a cut, arguing a planned gradual easing of capital controls requires higher krona returns.

The central bank agrees with “most” of the points made by the IMF, though it was Sedlabanki’s “privilege” to set the benchmark interest rate and the decision was primarily steered by the outlook for the macro-economy, Interim Governor Svein Harald Oeygard said at a press conference.

Addressing the capital restrictions, imposed at the end of last year after the failure of its biggest banks led to the collapse of the currency, Oeygard said Iceland will move toward easing the restrictions gradually this year, taking a “cautious” approach aimed at “maintaining the value of the krona.”

‘Sufficient Incentive’

“The concern of the IMF is that the lowering of interest rates will have an impact on inflation, which will then maintain a weak krona,” said Ingolfur Bender, head of economic research at Islandsbanki hf, the state-controlled unit of failed Glitnir Bank hf. “However, there are hardly any domestic factors that can fuel inflation.”

The reduction was smaller than labor unions and employers groups hoped for.

“This rate cut, if you can call it a cut, grinds to a screeching halt all our efforts to reach an agreement on a stability pact,” said Vilhjalmur Egilsson, director of the Confederation of Icelandic Employers.

The unions “anticipated that demands for drastic rate cuts would be met,” said Gylfi Arnbjornsson, president of Iceland’s Confederation of Labor. Higher rates “can lead to massive layoffs, less investment and fewer initiatives.”

‘Incentive’

Sedlabanki said yesterday interest rate decisions must “provide owners of krona-denominated bonds and deposits with sufficient incentive to continue owning them” when capital restrictions are removed. The island plans to lift them in stages over the next two years, the bank reiterated yesterday.

Non-resident investors hold about 630 billion kronur ($5.12 billion) in krona-denominated assets that capital restrictions prevent them from exchanging into other currencies.

Even with controls in place, the krona’s onshore rate against the euro has slumped 14 percent since the middle of March, representing the worst performance of all emerging market currencies tracked by Bloomberg in that period.

“Since there are some margins for avoidance” of capital controls “that are difficult to eliminate, preserving currency stability will continue to require a firm monetary policy stance,” Flanagan said on May 29.

Glacier Bonds

The central bank published a memorandum on May 28, saying holders of so-called Glacier bonds, krona bonds issued outside Iceland, can’t exchange the returns on their investments, and that other bondholders can only exchange returns accrued since they purchased the security, representing a tightening of exchange rules.

At the same time, the bank is trying to ease restrictions through controlled channels. The central bank on May 6 opened a loophole for foreign investors locked into their krona holdings. Investors will be able to swap them by funding Icelandic companies, which will repay the loans in foreign currency.

“It remains a key program objective to remove capital controls as quickly as possible, and in a manner consistent with currency stability,” Flanagan said on May 29. “The process can likely commence later in 2009, but will be gradual.”

The central bank said last month it sees scope for more interest rate cuts as inflation slows. The inflation rate dropped to a 12-month low last month of 11.6 percent. Sedlabanki has signaled it will continue to cut rates in smaller, more frequent steps, as it sees inflation reaching the 2.5 percent target by the beginning of next year.

“We still believe that the Sedlabanki inflation target of 2.5 percent will be reached early next year, as inflation will continue to decrease in the upcoming months, although it is coming down at a slower pace than forecast,” said Bender.

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik at valdimarsson@bloomberg.net.

Last Updated: June 4, 2009 12:14 EDT