Iceland Central Bank Raises Rates for First Time Since Banking Meltdown

Iceland’s central bank raised its benchmark interest rate for the first time since its banks collapsed in October 2008 and warned more increases may be needed after krona losses sent inflation to a 13-month high.

The seven-day collateral lending rate was raised a quarter of a percentage point to 4.50 percent, the Reykjavik-based bank said today. It had kept rates unchanged since March, when it ended a cycle of 15 cuts that started after Iceland obtained a $4.6 billion loan from an International Monetary Fund-led group.

The increase “reflects the fact that the inflation outlook for the coming two years has deteriorated still further since the committee’s last meeting,” policy makers said in a statement. Data and the latest forecast also “indicate that domestic demand and employment will grow more strongly in 2011 than was assumed in the last forecast,” they said.

The krona has lost more than 6 percent against the euro this year as the central bank considers how fast to scale back capital controls in place since the end of 2008. The bank has said it will take any policy steps needed to ensure a stable currency and avoid accelerating inflation. Consumer prices rose an annual 5 percent in July, the most since June 2010.

Policy makers said today that the effects of the “unrest” in financial markets and slowing growth in “major industrial countries” was “extremely difficult to estimate” and that a “modest” rate increase was unlikely to halt a recovery.

‘Abysmal Impact’

Today’s rate increase won’t prevent import prices from rising and may hurt any recovery, according to Valdimar Armann, an economist at Reykjavik-based asset manager Gamma.

“They are combating this inflation with interest rate increase, which is a tool which doesn’t work in this fight,” Armann said by phone. “This will have an abysmal impact on households, as many car loans and mortgages now track the central bank’s rate.”

The bank raised its forecast for economic growth this year to 2.8 percent from 2.3 percent, while lowering next year’s estimate to 1.6 percent from 2.9 percent. It expects inflation to average 4.4 percent this year and 4.9 percent next year, up from previous forecasts of 2.8 percent and 2.7 percent, respectively. The bank targets an inflation rate of 2.5 percent.

“It’s necessary to act now to contain inflation and reduce potential pressure on the krona,” they said. “This may call for further interest rate hikes.”

Krona Moves

The krona jumped 0.5 percent against the dollar to trade at 113.21 at 12:56 p.m. in Reykjavik. It strengthened 0.1 percent to 163.85 per euro.

Policy makers from Oslo to Washington have postponed monetary tightening or committed to extended periods of low borrowing costs as stock markets plunge, Europe’s debt crisis deepens and a U.S. economic recovery falters.

Capital controls, which the central bank estimates are stopping investors from selling about $3.6 billion in krona assets, may need to stay in place until 2015, Economy Minister Arni Pall Arnason said in March.

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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