Iceland Shelves Monetary Tightening as Krona Seen Appreciating

Iceland’s Sedlabanki Keeps Rates Unchanged as Inflation Abates
Security doors stand shut at the entrance to Iceland's central bank, or Sedlabanki Islands, in Reykjavik. Photographer: Arnaldur Halldorsson/Bloomberg

Iceland’s central bank shelved a cycle of interest rate increases as policy makers raised forecasts for the krona through 2014 after clamping down on currency speculators.

The bank, which kept its seven-day collateral lending rate at 5.75 percent today after raising borrowing costs five times in the past year, said the krona will average 150.1 per euro next year, almost 10 percent higher than previously forecast. It raised this year’s estimate by 5.5 percent to 156.3 per euro.

“The bank seems to anticipate that the krona will appreciate further through 2014, meaning that it will adversely impact Iceland’s balance of trade,” said Asdis Kristjansdottir, head of research at Arion banki hf in Reykjavik. “At the moment the country needs to generate more foreign exchange to meet its foreign exchange obligations. I’m therefore surprised that the bank doesn’t use the opportunity to purchase foreign exchange in the markets while the krona is so strong.”

The bank has been struggling to lift capital controls in place since the economic collapse in 2008. Policy makers raised rates at consecutive meetings from March to June in a bid to ease inflation. The government in March closed a loophole in its currency controls strengthening the krona by almost 14 percent and curbing price growth.

Faster Growth

The bank forecast that inflation will average 5.4 percent this year and slow to 3.4 percent next year and 3 percent in 2013. Gross domestic product will expand 3.1 percent in 2012, 2.2 percent next year and 3.4 percent in 2014, the bank said.

“The inflation outlook for the next two years has improved since the Monetary Policy Committee’s last meeting, although inflation is not expected to reach the bank’s inflation target until the end of the period,” Sedlabanki said in the statement.

The krona was little changed against the euro at 148.23 as of 9:14 a.m. local time.

Annual inflation slowed to 4.6 percent in July from as high as 6.4 percent in April. A stronger currency pushes down the cost of imports for the north Atlantic island, which targets an inflation rate of 2.5 percent.

Iceland, whose banks defaulted on $85 billion in 2008, completed a 33-month International Monetary Fund program in August last year. The island’s approach to its rescue has led to a “surprisingly” strong recovery, Daria V. Zakharova, the IMF’s mission chief to the country said in an interview this month. Fitch Ratings in February raised the island to investment grade, praising its “unorthodox crisis policy.”

Locked Assets

The country imposed capital controls in 2008 after the krona plunged as much as 80 percent against the euro offshore. The controls are stopping as much as $8 billion in kronur assets from leaving, according to an estimate by Arion Bank hf.

The country’s monetary policy has been out of step with the rest of the world, where central banks are keeping rates at or near record lows to guard against the fallout of a deepening European debt crisis.

Iceland’s $13 billion economy will expand 2.4 percent this year, the IMF said April 17. That compares with a 0.3 percent contraction in the 17-member euro area, the fund said.

Unemployment, which jumped nine-fold between 2007 and 2010, eased to 4.7 percent in July from a peak of 9.3 percent two years ago.

Iceland started European Union accession talks in 2010 and the government has said it targets euro adoption as soon as possible after joining the bloc. A poll by newspaper Morgunbladid published Aug. 13 showed that 39 of the 63 lawmakers in parliament oppose continuing talks and may push the legislature to address the option of dropping membership preparations before elections next year.

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