Iceland’s central bank cut its benchmark interest rate to 4.25 percent after inflation eased to the slowest pace in seven years and as demand slumped and capital controls supported the krona.
Sedlabanki lowered the seven-day collateral lending rate by a quarter point, the Reykjavik-based bank said on its website today. The bank also cut the deposit rate to 3.25 percent from 3.5 percent. Policy makers have reduced the benchmark 15 times from a record 18 percent since obtaining a $4.6 billion loan from a group led by the International Monetary Fund at the end of 2008.
“The economic recovery will be somewhat stronger this year than was forecast in November,” the bank said today. “While economic fundamentals and the capital controls continue to support the krona, the exchange rate has depreciated by 4.5 percent in trade-weighted terms since the December meeting.”
Capital controls, imposed after the failure of Iceland’s three biggest banks in October 2008, have protected the krona from a sell-off and allowed the island’s trade surplus to support the exchange rate. Still, the currency has slipped about 4 percent against the euro since a Jan. 7 high, as policy makers try to ensure the timing of currency controls doesn’t hurt the krona. The bank has said it won’t start easing capital controls until March at the earliest.
“With the prospect that inflation will remain near target and with interest rates at a historically low level, the direction of future policy moves becomes more uncertain,” the bank said.
The central bank needs to time the easing of capital controls without triggering a selloff of the krona that would fuel inflation and destabilize financial markets.
The bank estimates foreigners are locked into about $3.6 billion in krona assets -- mostly in the form of krona- denominated bonds issued outside the island -- that can’t be exchanged until the capital controls are lifted. Krona Eurobonds, known as Glacier bonds, will probably be the last to be freed from currency restrictions, Governor Mar Gudmundsson said in September. Bonds with the longest maturities will be exempt first, Deputy Governor Arnor Sighvatsson said.
Iceland’s economy grew in the third quarter for the first time in two years, expanding 1.2 percent from the three months through June. The economy will grow in 2011, the central bank estimates, ending the island’s longest period of economic decline since it won independence from Denmark in 1944.
The IMF finished its fourth review of Iceland’s economic program in January, freeing a $160 million payment. A team from the Washington-based lender will be in Iceland until Feb. 7 to discuss the island’s fifth review.
The economy will expand 2.8 percent this year, 3.2 percent in 2012 and 3.4 percent in 2013, the central bank said today.
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