Iceland Halts Tightening Cycle as EU Crisis Clouds Outlook

Iceland’s central bank kept interest rates unchanged as market turmoil triggered by Europe’s worsening debt crisis prompted policy makers to shelve a tightening cycle.

The seven-day collateral lending rate was left at 4.75 percent, Sedlabanki said today in Reykjavik, after last month raising rates for a second time since August. A separate report showed the economy expanded at the fastest pace in more than four years in the three months through September, according to quarterly data.

The bank said the decision to halt its tightening cycle was taken because “in the near term, the current level seems broadly appropriate in light of the economic outlook and potential international headwinds,” according to the statement.”

The central bank, known locally as Sedlabanki, is trying to ease capital controls, in place since the end of 2008, without triggering a krona slump that risks fueling inflation. At the same time, policy makers need to protect the economy from the fallout of the euro crisis, which threatens to drag down global growth and leave export-reliant nations like Iceland struggling to sell their goods and services.

“Looking further ahead, it will be necessary to withdraw the current degree of monetary accommodation as the recovery progresses and the slack in the economy disappear,” the central bank said.

Economic Rebound

Iceland’s economy grew at the fastest pace since the second quarter of 2007 in the three months through September, the statistics office said today. Gross domestic product expanded a quarterly 4.7 percent, after shrinking 3.6 percent in the previous period, the office said. The rebound was driven by a 6.8 percent increase in exports, while household spending grew 1.1 percent.

The central bank will probably deploy policy to protect the island’s recovery.

“We expect the bank’s interest rates to remain unchanged throughout next year,” Ingolfur Bender, an economist at Islandsbanki hf, said in a note before the rate decision. In 2013, the central bank is likely to “implement gradual tightening as the slack disappears and the economy approaches equilibrium.”

The krona pared gains against the dollar to trade little changed as of 1:24 p.m. in Reykjavik, after having gained 0.6 percent before the rate decision.

Iceland, whose banks defaulted on $85 billion in 2008, completed a 33-month International Monetary Fund program in August. The Washington-based fund expects Iceland’s economy to grow faster than the average for the euro area this year and next. It costs less to insure against an Icelandic sovereign default than it does to hedge against a credit event in Europe’s single currency bloc, debt derivatives show.

Iceland’s $12 billion economy will grow 2.5 percent this year and next, the IMF said in September. The euro area, by comparison, will grow 1.6 percent this year and 1.1 percent in 2012, the fund estimates.

Iceland’s currency has slipped 3.4 percent against the euro this year, while inflation has hovered at about 5 percent since July. The bank targets 2.5 percent price growth.

Iceland started European Union accession talks last year and the government has said it targets euro adoption as soon as possible.

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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