Iceland Central Bank Raises Benchmark Rate to Cap Inflation

Iceland’s central bank raised interest rates for a third time in seven months to contain inflation after the krona slipped and economic growth picked up.

The seven-day collateral lending rate was raised to 5 percent from 4.75 percent, Reykjavik-based Sedlabanki said on its website today. The bank indicated in February it would resume a tightening cycle it halted in December as it seeks to steer Iceland’s recovery and ensure a stable krona as capital controls are unwound.

“In the absence of an improvement in the inflation outlook, a further increase in nominal interest rates will probably be required in the near term in order to bring the monetary policy stance, which is still quite accommodative, to an appropriate level,” the bank said in a statement.

The bank is emerging from crisis mode as Iceland’s economy recovers from its meltdown in 2008. The country is trying to ease capital controls put in place in 2008 without allowing a sell-off of the krona. The currency has slipped almost 5 percent against the euro this year, while inflation was 6.3 percent in February, more than double the bank’s 2.5 percent target. The government last week closed a loophole in capital controls it said had allowed short-term investors to speculate on the krona.

Inflation Pressure

“The inflation outlook has gotten worse and it remains to be seen what the tightening of the capital controls will do in regards to strengthening the currency,” Ingolfur Bender, an economist at Islandsbanki hf, said by phone. “Added to this is the fact that a stronger krona might lead to greater consumer spending with further inflationary pressures.”

Islandsbanki predicts the central bank will raise rates to 5.5 percent by the end of the year, he said.

“But obviously worsening conditions might force the bank to raise rates even more,” he said.

The krona rose 0.3 percent against the dollar to trade at 125.61 as of 10:29 a.m. in Reykjavik. It was little changed versus the euro at 166.66.

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. Fitch Ratings in February raised the island to investment grade, praising its “unorthodox crisis policy.”

Economic Outperformance

“The government’s decision last week to tighten the capital controls will undoubtedly play a role in the bank’s” future rate decisions, Thorbjorn Atli Sveinsson, senior economist with Arion Bank hf, said in a note to clients before the announcement. “We believe that the bank will choose the moderate road” when it comes to raising rates and wait and “see what the effects of changed laws on capital controls will lead to in the coming weeks.”

Iceland’s $13 billion economy will expand 2.5 percent this year, the IMF said March 2. That compares with a 0.3 percent contraction in the 17-member euro area, the European Commission said Feb. 23. The U.S. economy will grow 2.2 percent in 2012, the World Bank said Jan. 18.

Iceland started European Union accession talks in 2010 and the government has said it targets euro adoption as soon as possible after joining the EU.

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

To contact the editor responsible for this story: Jonas Bergman at jbergman@bloomberg.net

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