Iceland’s Central Bank Cuts Rates to Limit Advance of Krona

Iceland’s central bank cut interest rates for the second time in four months as an appreciation in the krona is imperiling its inflation target and hurting exporters.

The benchmark seven-day term deposit rate was lowered by 0.25 percentage point to 5.00 percent, the Reykjavik-based Sedlabanki said Wednesday. The krona slid 0.3 percent to 118.77 per euro as of 9:36 a.m. local time.

“Inflation expectations appear more firmly anchored to the target than before, and the monetary stance has tightened to some extent, through the appreciation of the krona,” Sedlabanki said in a statement. “This gives the MPC some scope to lower nominal interest rates now. Nevertheless, strong demand growth and the aforementioned uncertainties call for caution in interest rate setting.”

The central bank finds itself in a difficult spot as the krona brings down inflation at a time when the economy is expanding at an almost 5 percent pace, wages are soaring at more than double that rate and unemployment is virtually non-existent.

After raising rates throughout 2015, the central bank has now gone into reverse as looser capital controls increase inflows of capital, pushing the krona up and inflation down below its 2.5 percent target. The inflows increased Sedlabanki’s international reserves to 799 billion kronur ($7.1 billion) in October.

Record tourist arrivals and western Europe’s highest interest rates have all helped boost the currency, which has gained more than 14 percent against the dollar and 16 percent against the euro since the start of the year. The central bank has recently been scaling back a build-up in foreign reserves, according to the minutes of its November meeting.

“The cut is in line with the inflationary expectations of the market,” said Valdimar Armann, an economist with asset manager Gamma. “It will possibly have some impact on the krona’s appreciation, although that depends much on the market’s reaction to the cut. This is a small but good step."

The government in June imposed new rules designed 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.

Wednesday’s rate cut follows Oct. 29 snap elections, which saw the Independence Party emerge as the country’s biggest political group while its ruling coalition partner, the Progressive Party, slumped. Other big vote winners include the Pirate Party. Three political leaders have so far attempted and failed at coalition talks.

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