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Iceland Keeps Rates Unchanged as Turmoil Threatens Recovery

Iceland’s central bank kept interest rates unchanged as market turmoil triggered by Europe’s worsening debt crisis forced policy makers to halt a tightening cycle started last month.

The seven-day collateral lending rate was kept at 4.5 percent, the Reykjavik-based Sedlabanki said today, while signaling further rate increases may be needed to cap inflation. The bank in August raised borrowing costs for the first time since the failure of the country’s banks almost three years ago.

“Global financial market unrest and weaker-than-expected output growth in the world economy create uncertainty about inflation and growth prospects in Iceland,” the bank said in a statement. “The risk of an adverse effect on the domestic economy has grown since the last MPC meeting.”

The bank is balancing policy to protect the krona as it scales back capital controls with efforts to support the economy amid a global market rout that threatens to undermine recoveries in Europe and the U.S. Iceland, whose banks defaulted on $85 billion in 2008, completed a 33-month International Monetary Fund program last month. Its economy is likely to grow faster than the average for the euro area this year and next, the IMF estimates, while credit default swaps on Iceland trade lower than the average for the European Union.

The Icelandic krona fell 0.1 percent to 116.75 per dollar as of 10:14 London time.

More Increases

While the benchmark rate remains at more than 4 percent, inflation held at 5 percent in August, pressuring policy makers to lift rates further.

“The Committee remains of the view that, in order to contain inflation, it may prove necessary to raise interest rates further” the bank said today.

Iceland has started easing currency restrictions, which the central bank estimates have locked in about $4.3 billion in krona assets.

Iceland’s $12 billion economy contracted 2.8 percent from the first quarter after growing a revised 1.9 percent in the previous period, the Reykjavik-based statistics office said on Sept. 8. Output expanded an annual 2.5 percent in the first six months, the agency said.

“The Monetary Policy Committee is concerned that a negative real interest rate might undermine the value of the krona,” Asdis Kristjansdottir, an economist with Arion Bank hf, said in a note to clients before the announcement.

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