Iceland Keeps Key Interest Rate at Record 13.3%

Sep 6, 2007 - Iceland's central bank kept its benchmark interest rate unchanged at a record high, citing a deterioration in the short-term inflation outlook as labor shortages push up wages.

Sedlabanki left the rate at 13.3 percent after 18 increases in three years, the Reykjavik-based bank said today on its Web site. All eight economists in a Bloomberg survey expected unchanged rates.

The bank reiterated a forecast that rates won't start to fall until the first half of next year after wages grew an annual 8.3 percent in July, helping to keep inflation above the 2.5 percent target. Robust domestic demand, house-price increases and "buoyant" lending growth also prevented a rate cut, the bank said.

"The inflation outlook has worsened since the bank's last monetary bulletin in July, mostly because of tension in the labor market," said Asdis Kristjansdottir, an economist at Kaupthing Bank hf in Reykjavik. "The krona is also a little weaker and the housing market is not cooling down as fast as we'd expected."

The krona lost 0.3 percent against the euro and was trading at 88.33 as of 11:22 a.m. in Reykjavik. The krona shed 3.6 percent against the European single currency last month.

Deterioration

"The short-term inflation outlook has deteriorated somewhat since the last interest rate decision," the bank said in comments published on its Web site after the rate decision. "Long-term prospects are unchanged, however."

House prices grew an annual 10.1 percent in August, accelerating for a third month and suggesting record borrowing costs have yet to feed through to the property market. Unemployment dropped to a seven-year low of 0.9 percent in July, the country's Labor Board said on Aug. 13.

The inflation rate fell to an annual 3.4 percent in August, Statistics Iceland said on Aug. 13. Consumer prices will probably rise an annual 4.2 percent this month, according to Kaupthing Bank hf.

"The economy is not cooling down fast enough for the central bank to reach its target," Ragnhildur Jonsdottir, an economist at Glitnir Bank hf in Reykjavik, said before the announcement. "Wages are going up, the labor market is quite tight and all these factors contribute to more inflation."

Rates Outlook

Policy makers probably won't start cutting the key rate until March next year "at the earliest," Jonsdottir said. The rate will drop to 9.25 percent at the end of 2008, Glitnir estimates. At Kaupthing Bank, economists don't expect the bank to start lowering the rate until May, bringing it to 11.5 percent by the fourth quarter of next year.

"Indicators suggest that domestic demand is still robust," the central bank said. "The labor market remains tight, turnover and housing demand are buoyant and the pace of lending growth has accelerated."

The economy will probably grow 0.2 percent this year, after expanding 2.6 percent in 2006 and 7.2 percent in 2005, the central bank estimates.

Gross domestic product contracted 0.1 percent in the first quarter led by a 28 percent slump in investments as the construction of aluminum smelters draws to a halt and the plants become operational.