Iceland Delivers Surprise Half Point Interest Rate Hike to Stem Inflation

Iceland’s central bank raised western Europe’s highest interest rate more than expected as risks of prices and wages rising out of control outweigh the signs of a cooldown.

(Bloomberg) — Iceland’s central bank raised western Europe’s highest interest rate more than expected as risks of prices and wages rising out of control outweigh the signs of a cooldown.

The Monetary Policy Committee in Reykjavik hiked the 7-day term deposit rate by 50 basis points to 9.25% on Wednesday, exceeding the 25 basis-point estimate by market participants. Governor Asgeir Jonsson said he’s not ruling out “some more” tightening.

Policymakers in the north Atlantic nation have struggled for two years to meaningfully cool the island economy that’s remained hot thanks to robust tourism and export revenues, while recent wage agreements have also been more generous than the central bank expected. 

Jonsson still left the way open for the key rate to go past 10% if needed but said the likelihood of that was “maybe lower” than when he first raised the possibility in May.

“I am hopeful that this will be enough,” he said in an interview after the decision. “But then again the Icelandic economy has a tendency to surprise on the upside. We don’t rule out that we have to do some more.”

Read More: Iceland Hikes to at Least 10% Can’t Be Ruled Out, Governor Says

The Icelandic krona — which has gained about 10% in trade-weighted terms from a January low — strengthened 0.3% following the announcement to trade at 143.11 versus the euro at 11:50 a.m. in Reykjavik. The central bank expects the average exchange rate to “fall marginally” over the forecast horizon.

Rate increases have of late focused on preventing a spiral of growing wages and prices, and employment contracts are set to be renegotiated this fall.

“The tension in the labor market means that in the run up to wage talks the central bank has to send a clear signal that it will continue doing what it can to combat inflation,” said Hildur Margret Johannsdottir, an economist at Landsbankinn hf. 

“Because this was a larger step than we expected it might be more likely they can try to keep rates unchanged next time,” she said, adding next moves are dependent on data, including inflation expectations that remain stubbornly high.

In setting policy, the central bank is casting its eye over the long term, paying less heed on short-term developments, it said in a statement. While consumer price growth has slowed in the past months from the highest level since 2010, two- and five-year inflation expectations of market participants were unchanged since May at 4.5% and 4%, according to the central bank’s survey published last week.

Read More: Iceland Inflation Slows More Than Expected, Easing Rate Pressure

Iceland hefty pace of tightening stands out in the region as neighboring Norway and Sweden are nearing the end of their hiking cycles over the next months. The European Central Bank has kept its cards close to its chest regarding potential actions in September, with both another rate hike or a hold possible, according to President Christine Lagarde.

Weaker growth in the first half means Iceland’s full-year economic growth is now forecast at 3.5%, “well below” the 4.8% forecast in May, the central bank said. The outlook for the next two years is broadly unchanged.

Home prices in the island nation — the main driver of price growth at the beginning of the tightening cycle — have declined two months in a row. The 12-month increase in housing prices in the capital area was 0.8% in July, compared with 25.5% same month last year. 

“I have been getting more hopeful during the summer because we have seen many things going in our favor,” Jonsson said, citing the housing market, currency strengthening and lower international inflation. “We also see an indication that private consumption is going down. What is problematic is that the real economy is booming.”

–With assistance from Joel Rinneby.

(Updates with governor’s comments from second paragraph.)

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