The central bank, which lopped 0.75 percentage points off its seven-day term deposits rate, also forecast the country's economy would shrink by eight percent this year.
It had previously anticipated 0.8 percent growth -- primarily due to an 80 percent plunge in tourism visits, one of its key sectors.
If the contraction is confirmed, it would be Iceland's biggest in a single year in a century. During the country's devastating 2009 financial crisis, the economy shrank by 6.77 percent.
Unemployment is expected to hit 12 percent in the third quarter and nine percent for the full year, with gross domestic product (GDP) returning to growth of five percent in 2021.
"Uncertainty is unusually pronounced, however, and economic developments will depend on the path the pandemic takes and the progress made in unwinding the associated public health measures," the bank said in a statement.
It has reduced its key interest rate by 3.5 points in the past year, and said it would "use the tools at its disposal" to shore up the economy going ahead.
Wednesday's cut was Iceland's biggest since December 2010.
The country's tourism sector accounted for 8.6 percent of GDP in 2017, the latest year for which data is available, according to Statistics Iceland.
The tourism board said however that tourism has yo-yoed since then.
The number of visitors in 2018 hit a record 2.3 million people, before falling by 14.2 percent in 2019, the sharpest drop since 1980, mainly owing to the collapse of no-frills carrier WOW Air.
This year, the bank said it expected only 400,000 tourists to visit the North Atlantic island, the lowest number since 2005.