Strong crown leads Iceland's central bank to lower inflation forecast

COPENHAGEN: Iceland's central bank on Wednesday cut its inflation forecast until the middle of next year, following a sharp appreciation of the country's currency.

The bank on Wednesday also left its key interest rate unchanged, and it suggested further gains by the crown might prompt it to lower interest rates.

According to the bank's new forecast, inflation is likely to remain below a 2.5 percent target until mid-2017. It will then hold between 2.5 and 3 percent for the remainder of the forecast horizon, which extends to the end of the decade.

The bank had signaled optimism over the country's inflation target in August, when it cut the seven-day term deposit interest rate by 50 basis points to 5.25 percent.

In an interview, central bank Governor Mar Gudmundsson said if no major upsets occurred in the labour market and economic policies remain aligned with monetary policy, "there might be a possibility of lowering nominal interest rates going forward."

Iceland's crown rose to an eight-year high against the euro after elections at the end of last month, when the centre-right Independence Party emerged on top and the anti-establishment Pirate Party fell short of expectations.

The crown has also strengthened 14 percent against the US dollar in the past year.

The bank said in a statement that the change in inflation forecast does not provide as much scope for monetary policy response as might be expected.

"What matters to us is that long-run inflation expectations are now aligned with the target," Gudmundsson said. Capital controls, imposed after the 2008 financial crisis to save the crown from collapse, have been partly lifted this year and are likely to be completely removed during the course of next year.

Restrictions on investment in overseas financial instruments were partly lifted last month, when residents were permitted up to 30 million crowns ($265,345.83). That ceiling will be raised to 100 million in January.

The central bank said in its statement that if households and businesses begin to accumulate foreign assets rapidly, a sudden surge in outflows would be "quite possible."

But raising the ceiling in January would be less significant than the first step, the governor said.

"The ceiling of 30 million crowns applies to a much bigger mass of people. We estimate that when we go up to 100 million crowns the ceiling will be binding on only 3 percent of households," Gudmundsson said.