Iceland Fights Carry Trade Threat With First Rate Cut Since 2014

As it dismantles the last remnants of capital controls that have protected its economy since late 2008, Iceland is now battling an inflow of fast money seeking to profit from its higher interest rates and outperforming economy.  

The central bank in Reykjavik on Wednesday cut its benchmark interest rate for the first time in 20 months as a surging krona has pushed inflation below target. The seven-day term deposit rate was lowered to 5.25 percent from 5.75 percent, the bank said. The decision marks a shift in policy after three rate increases in 2015.

“Improved terms of trade, low global inflation, tight monetary policy, and the appreciation of the krona have offset the effects of wage increases on the price level,” the bank said. “The krona has appreciated markedly in the recent term, in spite of substantial foreign currency purchases by the central bank.”

The krona was little changed at 131.7 per euro as of 12:42 p.m. local time.

The currency has rallied as investors flocked to the country’s higher interest rates. It has gained 7 percent against the euro this year, driving inflation down to almost 1 percent, well below the central bank’s 2.5 percent target. To be sure, the krona is still about 65 percent below its pre-2008 crisis levels.

The island this month announced it was starting to phase out the last traces of its capital controls after largely settling with foreign investors and creditors in its failed banks.

Other larger central banks have also been forced to use the rate weapon over the past years to prevent unwanted currency strength, including in Sweden and Norway, as well as Switzerland, Japan and New Zealand.

The Icelandic government in June imposed new rules designed to limit the inflow of fast cash, setting requirements for new offshore investors that included keeping 40 percent in reserve accounts in the island for at least one year, targeting bonds and deposits. The aim is to prevent a repeat of 2008, when speculative cash played a big role in pumping up the value if Iceland’s banking system.

The nation has won praise from economists and the International Monetary Fund for its handling of the 2008 crisis, which included writing off consumer debt and forcing haircuts on foreign investors. The economy has now largely recovered, with growth above 4 percent and unemployment down to 2 percent.

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