Iceland Raises Rates as Economy Heats Up Under Krona Curbs

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Iceland’s central bank raised its benchmark interest rate for a second time since June as it moves to counter the threat of overheating after seven years of capital controls.

The collateral lending rate was raised to 6.25 percent from 5.75 percent, the Reykjavik-based lender said on Wednesday. The decision follows a 50 basis-point increase in June.

Iceland is trying to prevent imbalances in its economy, which has existed inside capital controls since its financial system collapsed at the end of 2008. The government has started the final leg of a process designed to exit the restrictions, putting pressure on the central bank to ensure a stable exchange rate and consumer prices as capital flows pick up.

Economic growth of 4.2 percent this year and about 3 percent in 2016 means Iceland faces a “positive output gap” that will “widen in the coming term,” the central bank said. Gross domestic product will be “driven by domestic demand -- especially private consumption -- to a greater extent than in recent years.”

Iceland’s progress toward a freer currency will bring a new set of challenges, Finance Minister Bjarni Benediktsson said this month. In part, policy makers are keen to avoid making the Atlantic island a magnet for so-called carry trades, which destabilized the economy in the years leading into its most recent collapse.

“There are external boundaries to how much higher interest rates can be in Iceland compared to the surrounding countries, if we don’t want an abnormal amount of capital inflows,” Benediktsson said in an interview last week. “That must be one of the things that the central bank has to take into consideration when it sets rates; to not create this risk by raising rates too much.”

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