Iceland's Central Bank Cuts Rate to 5.5% as Stable Krona Slows Inflation

Iceland’s central bank cut the benchmark interest rate by three-quarters of a percentage point as inflation eased to the slowest pace in more than five years after capital controls shielded the krona and demand slumped.

Sedlabanki lowered the seven-day collateral lending rate to 5.5 percent, the Reykjavik-based bank said on its website today. The bank also cut the deposit rate to 4 percent from 4.75 percent. Policy makers have reduced the benchmark 13 times from a record 18 percent since obtaining a $4.6 billion loan from a group led by the International Monetary Fund at the end of 2008.

“They needed a deeper cut now to stimulate the economy; there’s a real risk of deflation next year and the bank has to anticipate that and react,” said Asgeir Jonsson, head of research at Arion Bank hf in Reykjavik. The bank may also try to keep rates low as capital controls are removed to prevent investors turning to kronur for so-called carry trades, a transaction that exacerbated the island’s crisis two years ago, he said.

Capital controls, imposed after the failure of Iceland’s three biggest banks in October 2008, have protected the krona. The currency has gained 19 percent against the euro over the past year, while the inflation rate fell 0.4 point to 3.3 percent last month, the lowest since June 2005. The central bank has signaled it may start scaling back currency controls at the end of this year, reducing its scope for more rate cuts.

Inflation Development

The rate of price gains has dropped to a fifth of the pace that plagued Iceland during the peak of the crisis. Inflation soared to 18.6 percent in January last year after the krona lost about 80 percent against the euro offshore in 2008. The krona was trading 0.2 percent higher against the euro today at 154.60 at 9:29 a.m. in Reykjavik. Against the dollar, the krona gained 0.1 percent to 110.23.

The IMF resumed its program with Iceland on Sept. 29, freeing a $167.5 million payment. The lender’s fourth review of the island’s economic program is scheduled for December, Prime Minister Johanna Sigurdardottir said yesterday.

The central bank estimates foreigners are locked into about $3.6 billion in krona assets, mostly in the form of krona Eurobonds that have remained in limbo since the controls were imposed. The bonds, known as Glacier bonds, will probably be the last to be exempt from currency restrictions, Governor Mar Gudmundsson said in September. Bonds with the longest maturities will be the first to be released from the controls, Deputy Governor Arnor Sighvatsson said at the time.

Iceland’s economy, which contracted an annual 8.4 percent in the second quarter, will return to growth in 2011, the central bank estimates, as the island emerges from its longest period of economic decline since records began in 1944.

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

To contact the editor responsible for this story: Tasneem Brogger at tbrogger@bloomberg.net.

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