Currency Springs Central Bank Trap as Iceland Risks Overheating

  • Rates may be cut as Iceland falls victim of its own success
  • Sedlabanki holds final rate meeting of the year on Wednesday

Economics text books would probably recommend against cutting interest rates in a country that’s growing at a supercharged pace of almost 5 percent, where wages are soaring at more than double that rate and unemployment is virtually non-existent.

Yet that’s precisely what the central bank of Iceland may need to do when it holds its final rate setting meeting of the year on Wednesday. 

Like many of its European peers, Sedlabanki is struggling to meet its inflation target. And much like in Sweden, strong economic growth is failing to lift consumer prices.

In Iceland, it’s all about the currency. With capital controls now being dismantled, the krona is surging due to a boom in tourism receipts and foreign direct investments. A stronger krona makes imports -- on which Icelandic consumers depend so much -- cheaper.

"It’s becoming unavoidable for the central bank to face the fact that it needs to cut rates," Johann Gisli Johannesson, a fund manager at Reykjavik-based asset manager Gamma Capital Management hf, said in an interview. “It has overshot its inflationary forecasts due to the strengthening of the krona.”

The central bank finds itself in a difficult spot. While its principle objective is a twelve-month inflation rate of 2.5 percent, it is also having to deal with the risks of an overheating economy. The latest to issue such a warning was the Organization of Economic Development and Cooperation.

U-Turn

That explains Sedlabanki’s recent U-turn.

After hiking rates throughout 2015, the central bank cut its benchmark seven-day term deposit rate in June. Its foreign currency reserves have since surged, while inflation is forecast to hover around the 2.5 percent mark through 2019.

While a strong krona risks causing economic imbalances, one of the short term benefits is a reduction in the price of borrowing, Steingrimur Arnar Finnsson, head of markets at securities firm Fossar Markets, said in an interview.

"We expect yields will continue to come down as the inflationary outlook is low," said Finnsson, who like Gamma’s Johannesson expects a rate cut, either this week or in February. "There may be a little noise now and again, but this is the long and medium term view.”

The outgoing government imposed new rules in June to limit the inflow of the kind of fast cash that proved fatal to the island in 2008, when foreign speculators helped push Iceland’s three main banks over the brink. The requirements for new offshore investors include keeping 40 percent of their balance in Icelandic reserve accounts for at least one year.

Although those efforts have had only limited effects so far, were it not for the restrictions Iceland’s krona would be appreciating even faster than it already is, Johannesson said.

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